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Rosetta Stone Inc. (NYSE:RST)

Q2 2012 Earnings Call

August 8, 2012 4:30 pm ET

Executives

Steve Somers – Vice President-Investor Relations

Stephen Swad – Chief Executive Officer

Thomas Pierno – Chief Financial Officer

Analysts

Peter Appert – Piper Jaffray & Co.

Jeff Mueller – Robert W. Baird & Company Inc.

Brandon Dobell – William Blair & Company LLC

Matthew Kempler – Sidoti & Company LLC

Thomas Allen – Morgan Stanley

Operator

Greetings, and welcome to the Rosetta Stone Inc. Second Quarter 2012 Financial Results Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Steve Somers, IR for Rosetta Stone Inc. Thank you, Mr. Somers, you may begin.

Steve Somers

Good afternoon. and let me welcome you to Rosetta Stone’s second quarter 2012 earnings call. I’m Steve Somers, Vice President of Investor Relations, and I’m joined today by Steve Swad, Rosetta Stone’s President and CEO; and Tom Pierno, CFO, to discuss the operations and financial results for the second quarter and our outlook.

In addition to our commentary today, we have made our 2Q ‘12 earnings result press release supplemental financial information, and a slide deck supporting this webcast, available on our IR website at investors.rosettastone.com. Please review them to find important additional information. There are or will be forward-looking statements in our press release, slides, and conversation today.

We offer these statements under the Safe Harbor provided by U.S. law, of course, risks and uncertainties attach to any forward-looking statements. A detailed discussion of such risks and uncertainties is contained in our Form 10-K filed with the SEC in March 2012, which is available in the Investor Relations section of our website. We ask that you review those risk factors before making any investment decisions.

Please note that these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to provide or publicly release the results of any revision to the forward-looking statements in light of new information or future events. We also use non-GAAP numbers in our presentation. The definition of those numbers and their reconciliation to GAAP numbers is available in today’s press release on our website and as filed with SEC today on Form 8-K.

Now here, Steve.

Steve Swad

Thanks, Steve and welcome everyone. overall I think the quarter came in largely as expected. If you recall in May, I said my strategic focus for the company is based on three pillars: leveraging the brand, innovating the platform, and expanding distribution. In pursuing these priorities, I committed to you that we would do it in a fashion that balances margins with growth.

Since we last spoke, we have made progress internally along each of these three priorities. As it relates to Q2 however, the best evidence of our progress was in the improvement in margins, which makes sense, because it takes time to meaningfully drive these other priorities.

Adjusted EBITDA came in at a positive $1.1 million versus a negative $1.3 million a year ago, which represents a positive margin of 2%. this performance fits into the 2% to 3% margin range that I outlined for the full-year 2012, and compares favorably to a negative margin of 2% a year ago.

To drive margins, we took a number of actions. For example, we reduced global headcount by about 5%. We closed over 100 low yielding kiosks since Q2 of last year. We removed low performing SKUs. We pulled back on lower yielding media. We reduced our cost structure in Europe by streamlining our operations in the UK and Germany. And we closed low yielding retail locations in Japan. These actions clearly made the company more efficient. However, some of these actions, particularly those around media and kiosks also resulted in lower revenues year-over-year.

Overall revenues for the second quarter declined 9% with our global consumer business off 11% and our institutional business off 2%. In North America, our consumer business faced somewhat weaker consumer demand, which we managed through some promotions that lasted longer than originally planned. Revenues in the quarter were 4% lower than last year and were influenced by several factors.

The first is that revenues from our kiosks were down, as we operated an average of 74 fewer kiosks this year compared with last year. While this impacted revenues by over $2 million, revenues per kiosk continue to increase year-over-year as we’ve made progress in optimizing this channel.

Despite an overall decline that was mainly driven by our reduced kiosk footprint, our direct-to-consumer channel was up nearly 10% as a solid lift in website traffic offset a slightly lower conversion rate.

On the International Consumer side, revenues declined primarily from our operations in Asia. Previously, I’ve indicated that our challenges in Asia were not likely to be resolved in the near-term, and that perspective was not changed in the second quarter. Because our international challenges are not universal, but rather more country-specific, let me touch on each geography.

Results in Japan were down because of declines in our kiosk retail and DTC channels. Part of the decline was due to our efforts to reduce poor performing kiosks and retail locations. In addition, our important DTC channel has not yet stabilized. While our Japanese business continues to struggle and we are still searching for the right pricing and marketing mix to return to growth, we still think Japan and Asia in general are very attractive markets for language learning.

To reinforce this point, I’ve dispatched Prag Shah, our Head of Consumer, to oversee our global consumer operations from Asia. Prag will work toward addressing our challenges in Japan and Korea, and I feel that having a senior management presence there will help lead to improvements.

Even as top line was below expectation in Japan, our focus on better managing costs including media spend enabled us to compensate somewhat for the lower revenues and come in better than we expected. Elsewhere in Asia, our business in Korea recorded top line that was down double-digits compared with a year-ago. As you know, over the past several quarters, we’ve been addressing issues relating to a slowing in our home shopping channel and trying to ignite growth in our ReFLEX product. We made some progress in the quarter as units from our DTC channel were up strong double-digits. In addition, we also experienced higher year-on-year sales in our kiosk channel.

As I’ve told you on the past couple of calls, our conversation in English product, ReFLEX has struggled to gain traction on the consumer side of the business. Part of the challenge for this product has been the immaturity of our web channel as well as the disruptive nature of the product in what is a very traditional consumer market.

While we’re seeing improved customer acceptance and better more targeted marketing, we have not yet generated a positive meaningful impact on the business results. In light of this, we’re expanding our efforts to find distribution partners and have introduced ReFLEX into the institutional market. We’ve seen some positive initial receptivity, but we are still operating at suboptimal levels.

During the quarter, we also managed the cost side of our Korean business tightly, which allowed us to improve adjusted EBITDA contribution versus last year despite the softer revenues. Our European business also experienced a decrease on the top line compared to last year, but improvements on the bottom line.

That being said, the revenue decrease in Europe largely reflects the shift in our Germany business from a box product to a 12 month online product. While revenues were down, we were still able to significantly increase EBITDA by spending less on media as we drove improved returns on that spend.

Together with expense reductions associated with closing our German office, we were able to improve margins meaningfully in Q2 2012. As we’ve discussed previously, this move to all online product offering in Germany, back in late February started out softer than expected.

In Q2, we still track below expectations, but we are gaining momentum. Particularly in our web channel as the market becomes more familiar with our offering and we become more effective at marketing this solution. While each of our markets have their own characteristics, we are in part using Germany, as a test market to think about how we can effectively offer similar solutions in other markets. I’m still not satisfied with where we are today in Germany, but believe we are progressing toward making our business more relevant over the long-term.

On the consumer pricing front, average revenue per unit was around $250 compared with roughly $360 a year ago. There were a number of factors that drove this decrease including the addition of lower ARPU monthly online subscribers in our metrics. In the second quarter, we also promoted more in the quarter than we did a year ago which impacted average pricing.

To help mitigate the downward trend in pricing, we are currently testing different tiers or bundles to address customer preferences along various price points on the demand curve. Some of our options include un-bundling certain elements of our TOTALe offering like Studio and selling some of those sessions as up sells. We expect that such action should help offset the recent downtrend in our pricing.

Now, let's move to our institutional business. As I mentioned to you back in May, we believe that we have an opportunity to grow this business. We had solid sales momentum in the second quarter inking a number of large deals. However revenues were down 2% year-over-year. Similar to what we experienced in the first quarter, our K-12 market is soft versus the prior year, due to a sunsetting of 2011 federal stimulus money that drove demand for our solution in schools. Our international business continues to make nice gains as we sold more and we sold more into the U.S. corporate and higher ed channels.

During the quarter, we even grew our government business excluding the headwinds from the 2011 non-renewal of the Army and Marines contract, which will persist into the third quarter. Institutional is an important segment for us, and we are investing in people, marketing, and systems to position us to capture this opportunity.

Before turning the call over to Tom to review the financials, let me make a couple of comments regarding where we are today, and where we are headed. We are clearly making progress around operating efficiencies. What is more difficult to see, however, are the initiatives that we are working on to address our strategic priorities? Among those is the development of a product for kids, which will leverage our brand in both the consumer and institutional segments.

In addition, we are working with potential partners to broaden our distribution and expand our reach both in the U.S. and internationally. We are also making investments to innovate our platform including efforts around artificial intelligence and a new learner management system for institutional users. All of this is being carried out with a careful eye on cost.

I've used the phrase “cutting back on empty calorie” revenues to describe some of the actions that we have and are taking to improve the business in the short-term. And the second quarter was a good reflection of how we are working to ride the ship financially, to set us up for profitable growth in the future. By no means, am I saying that we've got it all figured out, but I believe we are making the Company stronger and more relevant.

Now, let me turn the call over to Tom, who will review our financial results in detail.

Thomas Pierno

Thanks, Steve, and good afternoon, everyone. As Steve noted throughout his commentary, the second quarter was one that saw us take steps to improve the profitability of the Company. This resulted in us generating less robust results on the top line, but driving margin enhancement and strong improvement in adjusted EBITDA versus last year.

Total revenues in the quarter decreased 9% to $60.8 million, this reflected in a 11% decrease in our consumer segment, predominantly driven by lower revenues from our international markets, but also modestly lower results in North America as well.

Institutional revenues were up 2% due to the absence of the Army and Marines contracts and the softness in the K-12 vertical. Adjusting out for Army and Marines, revenues would have been up nearly double-digit percent in the quarter.

Average revenue per unit was down in the quarter to $246 from $362 a year ago and $290 last quarter. There are a few main reasons for the year-over-year decrease, some of which represent lower prices for our products, and some of which reflects the mechanics in how we calculate the metric.

First, it reflects the blending in the calculation of our metric of hard box units with the increasing number of lower-priced online monthly subscriptions. This accounts for about half of the change. Second, it reflects impact of lower pricing and promotions in 2Q 2012 versus last year. And third, it reflects a channel shift away from our own kiosk channel with higher average pricing compared with pricing that we get from our retail partners.

As you have seen in recent quarters, our reported ARPU has been decreasing in part because of the expansion of the number of units through an increasing amount of new and renewable monthly online subscribers in our unit count. Because more of our business is shifting online, we are working on expanded disclosure in the coming months that will include a breakout of physical box units versus subscribers and related average pricing metrics.

We expect that after we provide this disclosure, ARPUs on our box units will change by eliminating the noise associated with monthly subscriber ARPU, but still showed trends similar to what we have reported although less pronounced. We look forward to discussing this with you on subsequent earnings calls.

Gross margin held even with the first quarter at 81%, but was down from 83% in 2Q 2011. We managed down our hard product and inventory costs in the quarter, but these gains were offset by increased support and coaching costs. As we have noted the past few quarters, our gross margin is compressed with the introduction of Live Studio and our V4 and ReFLEX products.

Even as coaching costs in absolute dollars have increased, we continue to gain leverage on our fixed infrastructure as Studio sessions increase, in part driving a 25% decrease in per session cost. We are also currently exploring additional measures to further address coaching costs, including potentially capping the number of sessions versus the current unlimited practice and offering up sell coaching bundles to those who want more of them.

Consistent with our theme of better managing costs and focusing on margins, operating expenses decreased 10% to $54.5 million from $60.7 million a year ago. The improvement in operating expenses was driven by a $5.4 million decrease in sales and marketing expenses to $35.1 million from $40.5 million with the bulk of that coming from lower media spend across all of our markets. This drove the 300 basis points improvement in sales and marketing to 58% as a percentage of revenues.

Research and development costs increased slightly to $6.5 million from $6.4 million a year ago, while general and administrative expenses decreased $900,000 or 6% to $12.9 million. In total, cost of goods sold and operating expenses decreased 9% versus a year ago, more than offsetting the 9% decline in revenues.

During the quarter, we implemented modest cost saving measures, which included some headcount reduction. While we expect that these actions will improve margins going forward, there were expenses associated with these actions of almost $1 million that are in 2Q.

Excluding these and other similar costs, adjusted EBITDA for the quarter was a positive $1.1 million compared with a negative $1.3 million a year ago. Adjusted EBITDA margin improved 400 basis points to a positive 2% from a negative 2% a year ago.

Net loss for the quarter was $4.5 million or $0.22 per share, which was flat with the net loss of $4.5 million or $0.22 per share a year ago. Share count in the quarter was $21 million versus $20.7 million a year ago. From a channel perspective, our worldwide direct to consumer channel was flat with last year with revenues of $31 million. The reduction in our kiosk footprint over the past year to 99 global locations at quarter end resulted in lower sales of $4.6 million from this channel compared with $7.4 million a year ago.

While the reduction of locations has impacted top line, sales efficiency in this channel improved sharply as average revenues per kiosk were up 37% versus a year ago. As has been our plan, we are shifting resources from less efficient channels like kiosk to more effective ones like our web channel. The global retail channel produced revenues of $8.1 million down from $10.8 million. Part of this decrease reflects our more careful management of retail partners and the timing of purchases by retailers also impacts our quarter-to-quarter results.

More telling was the low double-digit increase in U.S. retail sell-through to the end-consumer in the quarter. This reflected strong results from our larger partners as well as a full quarter of selling through Best Buy and the addition of Canadian retail sales that we began late last year.

Turning to our financial position. the company’s balance sheet remained very healthy with $120.4 million of total cash, cash equivalents, and short-term investments, which was up from $118.5 million at the end of the first quarter and up $5.2 million from $115.2 million a year ago. This represents approximately $5.75 of cash per share. We also better managed our working capital with our accounts receivable, days outstanding, and our inventory levels both lower than a year ago, reflecting both the modest shift towards online offerings, but also reduction of our SKUs in the system.

CapEx in the quarter was $1 million as we generated $2.4 million of free cash flow, compared with negative $5.8 million in 2Q of last year. This represents the third consecutive quarter of positive free cash flow. For the first half of the year, free cash flow was $4.1 million versus negative $7.5 million for the comparable period last year, largely reflecting the improved operating results.

In May, we provided full-year 2012 guidance for revenues of $270 million to $285 million, and adjusted EBITDA of $5 million to $8 million. We also indicated that the quarterly pattern of adjusted EBITDA would directionally follow that of 2011 with most of our EBITDA upcoming in the fourth quarter.

Today, we are slightly modifying our guidance to increase the bottom end of our adjusted EBITDA range to now be $6 million. So, our full-year 2012 range is now $6 million to $8 million. Given the measures we’ve taken to address margins and costs, we believe that we can achieve this level. However, given that revenues in 2Q were down, in part as a result of our focus on improving margins and yields, we are keeping our revenue guidance unchanged at this point.

Since we last spoke to you, we have determined that we plan to proceed with further litigation in our trademark infringement case against Google Inc. We anticipate that second half 2012 legal expenses related to this matter could be in the low single-digit million range, which are not included in our adjusted EBITDA or net income and EPS guidance. In addition as a reminder, we previously indicated that we expect third quarter margins to be tighter due to a more competitive advertising market.

I’d also like to reiterate that starting today; we are no longer going to be providing bookings as a metric. while this metric is useful for internal management purposes. It can create confusion from an external reporting perspective and we want to be consistent in our discussion of results.

In addition, given our GAAP losses in 2011, it’s notably in our U.S. operations. The company is required to evaluate the potential for a non-cash valuation allowance against its deferred tax balances. Our evaluation of our Korea subsidiary’s recent losses combined with forecasted performance led us to conclude a full valuation allowance was needed to reduce the deferred tax assets of the Korea subsidy.

As a result, the non-cash charge of $0.4 million was recorded during the three months ended June 30, 2012. While we have not taken a valuation allowance against any other deferred tax assets currently, it is possible that we may have to take a non-cash valuation allowance in the future of up to $17.3 million.

Given the fact that through June 30, 2012, the company is ahead of its forecast and new leadership has taken steps to enhance profitability by cutting costs, management believes it is more likely than not that the net deferred tax asset will be realized through future taxable earnings, but we will be evaluating this each quarter.

With that, operator, we are ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Peter Appert with Piper Jaffray. Please proceed with your question.

Peter Appert – Piper Jaffray & Co.

Thanks. So Steve, I was hoping you could just give us an overview of your assessment of the competitive dynamic in the market, how it’s changed, if just you have a different point of view today versus when you took over a year-ago?

Stephen Swad

Hi, Peter, it’s Steve. I took over in the beginning of the year. It feels like longer than that, but it hasn’t been that long. But I will answer it in that perspective anyways. I feel pretty much the same as I did when I spoke to you in May. Yeah, competition is everywhere. It’s strong in Asia. It’s strong in K-12. The apps as you know are populating and satisfying the need of casual learners, but that environment is what we’re used to. And so I don’t have any news to report on that front.

Peter Appert – Piper Jaffray & Co.

I guess I ask it just in the context of the relative weakness in revenues, obviously I heard what you said. I know there’s specific operational execution issues. But I’m just trying to figure out if the underlying market environment maybe has fundamentally changed that is just adding to the challenge beyond some of these execution issues you’ve mentioned?

Stephen Swad

Yeah. Peter, to me the phrase that I used in May and used again today was part of our actions that we took deliberately was to scale back on media, particularly media that was not generating returns that sufficient to warrant it. And I attribute kiosk closures, closures of low performing retail locations in Japan and strong reductions in media as the major drivers for the revenue reduction. And I lump those kind of into a big bucket that I call empty calorie revenues where it was costing the company a fair amount of money to get those revenues.

Peter Appert – Piper Jaffray & Co.

Okay, fair enough.

Stephen Swad

So, I attribute the margin expansion essentially to that. Yes, revenues came down, but cost also came out and the residual was a net positive to the company.

Peter Appert – Piper Jaffray & Co.

Right, and what should we watch or what would you advise us to watch most carefully in terms of specific product offerings over the course of the next couple of quarters, where you think there is the most interesting potential?

Stephen Swad

Yeah. I don’t see new products coming out between now and the end of the year. What we are doing is enhancing our flagship product, TOTALe, making it more mobile, making the web interface more current. We’re adding some features that will be more social. So, there’ll be stronger connections between learners.

Peter Appert – Piper Jaffray & Co.

All right.

Stephen Swad

And I’m pretty excited about all that stuff. We also are in the midst of testing how we play efficiently at multiple points along the demand curve. So we’re trying to test into some offers at different price points in different bundlings. And so that’s what I think you should be watching for and I would say that’s more Q4 than Q3.

Peter Appert – Piper Jaffray & Co.

Okay. And then one last thing, then I will get off. Any early look at how we should think about 2013 reasonable to expect, you can get back to positive revenue growth you think at this point?

Stephen Swad

I’m not going to comment on 2013 yet. I’ll probably wait a couple quarters before I do that. I will say that in May, I laid out 2015 at plus $400 million in revenue. And low double-digit operating margins and I felt good about it then, and I continue to feel good about that target now.

Peter Appert – Piper Jaffray & Co.

Great. thanks, Steve.

Stephen Swad

Okay.

Steve Somers

Hi, Peter, it’s Steve Somers and to everyone on the call, just wanted to let you know that during the call, it was brought to our attention that we had a technical issue with the press release. So it should have hit wires some time ago and it’s on our website, so apologies for the delay in that. Stacey, I think we can go to the next question now.

Operator

Thank you. Our next question comes from Jeff Mueller with Robert W. Baird. Please proceed with your question.

Jeff Mueller – Robert W. Baird & Company Inc.

Yeah, thank you. Just wanted to know if you could kind of gauge how far along you are of cutting out the low calorie revenue, and how much more whether it be closures of locations or scaled back advertising we should expect over the remainder of the year?

Stephen Swad

That's a very good question. We are well into it, and I was pleased with the progress we’ve made in the quarter. I think, we have room, the mind shift of the company as I said was the focus on the three priorities I laid out, and balance our view between growth and margins. And that's what we did in Q2, and that's what we're going to continue to do. I can’t say, we also, I think Tom mentioned that Q3 we're expecting to be a tougher media market because of the elections. And so you will see less efficient marketing, we’re forecasting less efficient marketing in that quarter than normal. But other than that, we're turning our dials and making sure we're getting returns, we did a good job of that in Q2, and we're going to continue that.

Jeff Mueller – Robert W. Baird & Company Inc.

Okay. And then as you look out over the next couple of years, do you expect pricing to continue to come in on an apples-for-apples basis looking out similar products whether it be through list price or discounting?

Stephen Swad

That's a very good question. I feel comfortable right now with our pricing zone. As I mentioned, I’d like us to be a little more sophisticated in the way and play in multiple points along the demand curve, and we have some ideas on how to do that. My expectation is that that will help the average pricing. And I'm hopeful that through innovation and through adding more value that we’re able to hold these price points as we look into the future, but as you know that’s hard to forecast with certainty.

Jeff Mueller – Robert W. Baird & Company Inc.

Okay. And then just given your commentary about offering some of the solutions more a la carte, could you just talk about the coaching utilization?

Stephen Swad

Yeah, we're doing better. I think Tom mentioned that that our sessions are up, but our class per session is down, some of that comes from being better, some of that comes naturally with volume and scale. I would expect us to continue doing better. As I mentioned, one of the things we're looking to do is to price up-sell our real super users so that we get compensated for large consumptions of coaching and we're working on that as well.

Jeff Mueller – Robert W. Baird & Company Inc.

Great, thank you.

Stephen Swad

Okay.

Operator

Thank you. Our next question comes from Brandon Dobell with William Blair. Please proceed with your question.

Brandon Dobell – William Blair & Company LLC

Thanks. A follow-on from the previous line of question around the pricing zone. Given what the ARPU was this quarter versus last quarter versus kind of 20% breadth of price, what is that pricing zone? Is it the level we are at right now, is it something between where you were this quarter and last quarter?

Stephen Swad

Good question, Brandon. I'd say where we are now, and where we were last quarter is a decent zone. What we're going to do for you in the coming months and probably talk about it next call is we're going to breakout the online “units”, and separate those out, we call them subscribers or learners here. We're going to break those out from box sales, and we will be able to talk in a more sophisticated way about that. But do I think I can get $250 to $300 out of a learner for teaching him a new language? Yeah, I do, I do.

Brandon Dobell – William Blair & Company LLC

Okay. And I guess within that range given your comments thus far about the a la carte service component of that, I would assume that $250 to $300 is kind of exclusive of what you think would be possible for those super users, the high-end consumers or I guess high-volume consumers of the more service component of the business?

Stephen Swad

Yeah. So I’d agree with that.

Brandon Dobell – William Blair & Company LLC

Okay.

Stephen Swad

I think to say differently, I think there could be a range around that average both on the upside and on the down. So, can we pick a point less than 250 for you introductory learner and can we pick a point north of 250 for your higher and more serious learner? The answer to that is yes, and that’s exactly what we’re working on?

Brandon Dobell – William Blair & Company LLC

Okay. And it’s like to that point I remember going back even around the time of the IPO and I think the thought process was that there was just a little uncertainty around how the brand would play or not play once you got down into several $100 price level or even sub $200 price level, just given that the connotation of those price points is more about translation, and it is about learning. Have you guys kind of rethought that price point versus what it means for the brand perspective or should we expect to kind of a different strategy to get down to that, let’s call it sub $150 price point.

Stephen Swad

It’s a good question. As you know, I wasn’t around in 2009.

Brandon Dobell – William Blair & Company LLC

Yeah.

Stephen Swad

I bet you our views have changed, just because the tablet is new when it introduced. Apps, they’re new, and so my take on the brand is we need high-quality product that works in that’s kind of my metric. And then we’ve got to provide value at various price points. And so, that’s kind of my principle.

Brandon Dobell – William Blair & Company LLC

Okay. As you guys worked through the different months in the second quarter, how did the – let’s call it the U.S. only business are exclude international and institutional for a second, so let’s call it U.S. consumer. How did that trend, did you see what you’ve expected in terms of volume versus price trends? And I guess the subset with that question, how much experimentation was going on in the middle of the quarter that gave you some good feedback on what direction to take as you pushed in the back half of the year?

Stephen Swad

I would say as I said on balance, the quarter came in as we thought. I would say, we experienced a little stronger headwind in the U.S. just a little bit. And some of that was, I call it self-inflicted or the cost of testing. And so big picture, we were in the zone of where we thought we’d be.

Brandon Dobell – William Blair & Company LLC

Okay. And then final question. As we think about kiosk count for the second half of the year, since it wasn’t much movement between Q1 and Q2. Do you guys kind of found a base level of operations you are comfortable with in terms of productivity or is there another swipe or two, especially in the U.S. count? Thanks.

Stephen Swad

Yeah, Brandon. I think we’re in the zone there. I think we’re in the zone, we’ve got folks that are optimizing within that zone. So you may actually see a lift up here, and then a small decline there. But if I feel like the returns on that capital deployed are pretty good right now, and if they stay where they are right now, I’d expect them to continue in the same zone.

Brandon Dobell – William Blair & Company LLC

Okay, great. Thanks, guys, I appreciate it.

Stephen Swad

Okay.

Operator

Thank you. Our next question comes from Matthew Kempler with Sidoti & Company. Please proceed with your question.

Matthew Kempler – Sidoti & Company LLC

Thank you. It sounds like the institutional segment is one area that continues to be strong. so I was wondering if you can elaborate a little bit more on, if you’re seeing that in both North America and you’re strengthening internationally. And maybe update us on your efforts to kind of build the separate pro-branding effort?

Stephen Swad

Yeah, a great question Matt. Yeah, I do feel better about the institutional business this quarter than I did even when we spoke last May. and as I said, the bright spots there are international and corporate, and even in higher ed. We’re seeing some nice progress, and so I feel good. we’ve made some investments in people in that area. we’ve also made some investments in systems and process. and I feel like in the beginning stages of seeing some dividends there, and I have been and continue to be a big fan of that business. So you’re right, that good news is muted a little bit by the hangover that we have from the Army and Marines, as I said.

and K-12, we were beneficiaries of stimulus money last year and that money is gone. And so we’re seeing headwinds in K-12, principally around the inability to kind of quote renew on one-time stimulus money. Net-net I feel pretty good about that business.

Matthew Kempler – Sidoti & Company LLC

In what quarter do we pass the anniversary of the Army Marines and of the K-12 stimulus ending?

Stephen Swad

We have some in Q3 left and then we’re clean in Q4.

Matthew Kempler – Sidoti & Company LLC

Okay. All right.

Stephen Swad

And just to round it out, I also saw good news in Korea. It was kind of embedded in my comments, but excluding home shopping, I feel better about our DTC channel in Korea today than I did a quarter ago and our TS channel in Korea is stronger. And so there was little nuggets of goodness there. And in U.S. our DCT channel, which is the largest channel, continues to do well and so I feel good. And even to lesser extent, but also it's a trend thing. The trends in Germany are more green and red, and so when we launched in February, as I said, we were not hitting the metrics that we thought, we’re still not, but we're closer. And so I’m hopeful that we continue to see Germany kind of move in the right direction.

Matthew Kempler – Sidoti & Company LLC

Okay. And then you also mentioned that you are increasing your focus on distribution partners, and I know that something that you brought up at the Analyst Day, so I'm curious, are we in test now with various partners or we still in the identification stage?

Stephen Swad

No, no, no, we are working on deals around the world, we have signed some small ones, very small which isn’t terribly noteworthy other than to say that you’re starting to see some benefit from this being one of the priorities of the company, but I don't have anything meaningful to report on that front.

Matthew Kempler – Sidoti & Company LLC

Okay. And then the subscription side, I know when the quarter is out you’ll start to get some more detail in granularity, but can you give us a percentage range even of what the up tick subscription product at this point in the consumer side. And is this an option you are pushing at all in the U.S., or are you waiting on the completion of the Germany experiment before you do that?

Stephen Swad

I'm not going to get super specific, but think low single-digits. It’s a small part of our business right now. Last week or this week, we changed the rails underlying our website, and made it friendlier and easier to use in the program. And if you look on it right now, you see that we are leading with an online offering, and so that kind of answers your question a little bit. So while it is a small portion of our business, this minute, it is a portion of our business that we are promoting more actively today than we did even two weeks ago, and I expect that to continue as we move forward.

Matthew Kempler – Sidoti & Company LLC

Okay, thank you.

Stephen Swad

Okay.

Operator

(Operator Instructions) Our next question comes from Miles Jennings, Private Investor. Please proceed with your question.

Unidentified Analyst

Good afternoon. Excuse me, if this has been asked before, but this is the first time I’ve signed into your call. I think that your release of the iPad version was about 28 days ago, and I just wondered if could give us some offhand comments on take up of that product. And my second question is, and I don't think this would have an impact, but just want to ask it. Would this litigation with Google in any way slowdown the Tablet with Android?

Stephen Swad

Miles, this is Steve. Welcome to the call.

Unidentified Analyst

Thank you.

Stephen Swad

The iPad release is part of a – kind of a initiative and we call it a platform initiative to make our products more mobile. And so, it's a key element of that. And so that's what you're seeing, you’re seeing our median advertising focus on more mobility, you’re going to see more of that as we progress. And it's way too early to talk about uplift, but we anecdotally there – people love it. I use it on our iPad, it’s a wonderful thing. You can go on your back porch and sip a glass of wine, and you can learn a new language. And then kids, who are not of drinking age, are in schools and soon we will be bringing, that product is now available to schools as well. So, we’re excited about that. We’re excited about moving our product to be with you wherever you are. The call connected learning internally and that’s a key element of our connected learning vision.

With respect to the litigation on Google, my view is that I’m not expecting that to slowdown progress, you never know. Actually, it’s a good question. I’m not part of it. Our product works on the Android right now, on certain Android model. So, I would be surprised if that were an outcome, but it’s possible. I don’t want to say it couldn’t happen.

Unidentified Analyst

Good, thank you. Just a comment, I know with these tablet applications that even though it’s only been a month, since you released it. Just by being there you can sense whether or not it’s being explored whether it’s being subscribed to, and you can see the momentum either way. And so that’s why I ask the question, and I think got sort of a constructive answer from you on this iPad question?

Stephen Swad

Thank you.

Operator

Thank you. Our next question comes from Thomas Allen with Morgan Stanley. Please proceed with your question.

Thomas Allen – Morgan Stanley

Thank you, guys. I know you stopped giving quarterly guidance, but just for the third quarter, there are lots of puts and takes with the Olympics. You’ve talked about in terms of lower productivity on marketing and also with some of the cost cuts that you did this past quarter. Can you give us some kind of higher level explanation kind of on how costs should run? How you expect demand is running? And then do you think you got any pickup in demand because of the Olympics? And any color there would be helpful? Thanks.

Stephen Swad

Good questions, Tom. Yes, I’m not going to provide any more insight into the quarter than I have. Our full-year guidance, we tightened up a little bit. We feel pretty good about where we are relative to that. This quarter, I said big picture is about what we thought. You can kind of implies maybe a little bit better than we thought, because we lifted the bottom end and you’d probably be a little bit right on that.

And just to know that Q3 is going to be a little tougher than it has in the past, because of the Olympics. With respect to the Olympics, we are pitching. It’s hard for us to know whether that’s working or not, but that’s certainly – it brings the world together and that’s a core theme to us, and so I would hope that it’s helping. Although, I couldn’t point to anything, I would say it with our data.

Thomas Allen – Morgan Stanley

Okay. And then you’ve been decreasing sales and marketing, I understand a lot that’s kind of switching out of the zero calories cuts as you call them. But do you know what would be a time, or could you envision a time when you’d actually start increasing the costs? Do you see a scenario where you would see more efficiency and you would ramp up to spend, you obviously have a lot of cash, and so if you kind of afford to do that?

Stephen Swad

With [regard] to last three kind of single number drive too much, so our online spending is up. Our social spending is up, and our search spending is up. So, what we pullback on some kiosk marketing, we pullback on print marketing, and so there are a bunch of moving pieces there. I actually think, when I think longer-term, and I told you this would be one of the biggest area where I saw margins expanding that we were north of 60 points on revenue, and I don’t know, I think this quarter we were in the 50s, mid-50s, and that’s what I said we're going to do, and so I’m doing it.

And so I wouldn’t look at the absolute cost, I would look at it relative to revenue. And you should see contraction, I think I guided in the 50s, I said we're going to go from north of 60% to somewhere in the 45 to 50 points by 2015. And that’s still etched in my mind, pulling out empty calories is one thing. Another important one is, if we can get some progress around these distribution deals, I find that that is a more efficient rev share kind of pay for performance type relationship and that you should see revenues grow but the cost to get to those revenues will be much less than what our current average is.

Thomas Allen – Morgan Stanley

Okay, that's very helpful. And then finally a numbers one, it look like you had some new EBITDA adjustments in Q2. Can you explain what those are?

Stephen Swad

I may ask Tom to do that. My take was, we are in the midst of restructuring the company. And so in the quarter, we had shutdown cost in Germany, we had some severances relating to some contractions in headcount. We had some closures in Japan, I think and so, it was taking those costs and aggregating them and adjusting adjusted EBITDA for those costs, and we did the same thing last year, so you are looking at apples-to-apples. And we put a slide in – our release to kind of lay that out clearly. Tom, I don’t know if you…

Thomas Pierno

What we’re trying to do is take the noise out of the results that we have injected through the restructuring activities. And, as Steve said, we see this as a period of restructuring and so we’ve confirmed our presentation of the prior results where we have talked about these elements and called them out I think in prior calls and disclosures, but we haven’t normalized adjusted EBITDA for that and so, what I’ve done and we’ve done this quarter is actually kind of codified into that our definition of adjusted EBITDA, and that will be our definition going forward.

Stephen Swad

And it’s also the one we use internally, which I think is important. It’s the way we look at the business.

Thomas Allen – Morgan Stanley

Okay, thanks.

Operator

There are no further questions at this time. I would like to turn the floor back over to management for closing comments.

Stephen Swad

This is Steve. Thanks everybody for taking the time. My big picture takeaways from the quarter are, it was a quarter where I did what I said I would do. We took actions on cost. We moved Prag to Asia, or he's actually in the midst. I think that's important strategically. We're making progress on the platform. We're making small progress on distribution deals, and we are investing in the brand by – through the product and making modification of the product to make it more appealing to customers. I feel good about where we are and I feel good about what's in front of us. So with that, we're going to sign off. Thank you very much.

Operator

This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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