One thing I look for in security selection are prices that are experiencing a large, temporary dislocation for specious reasons, rather than for any significant change in the underlying value of the business.
In the case of Rosetta Stone (NYSE:RST), shares sold off drastically in November due, in part, to one of its private equity investors, ABS Capital, being forced to sell a large block of shares as it wound down its liquidating trust in which RST shares were held. Typically, PE funds invest with a certain time horizon - usually 7 years. Therefore, I understand that ABS Capital was selling for no other reason than because it was forced to sell (it acquired its stake in Rosetta Stone in 2006).
To add to the selling pressure, Rosetta Stone issued muted revenue guidance (no change in EBITDA guidance) on account of closing its "zero calorie revenue" kiosk distribution channel, without finding adequate revenue replacement for what was the remainder of 2013.
These transitory issues are actually quite fortuitous for Rosetta Stone shareholders, as the forced sale and selling pressure allowed management to buy back 1 million shares at $11.50/share, equating to 5% of the company's equity. This was a very accretive use of excess cash, in my opinion.
The company still has another $13.5 million remaining in its buyback program, and has shown its willingness to be opportunistic with its share repurchases. Continued weakness in Rosetta Stone's share price could provide management another opportunity to exhaust the program, thereby making remaining shares more valuable and adding downside protection. I estimate that the company has about $60 million in net cash after a number of recent acquisitions closed, including Tell Me More ($28 million) and Vivity Labs ($12 million) which were finalized earlier this month, and Lexia Learning ($23 million) and Livemocha ($9 million) which were acquired earlier in 2013 (and reflected in the balance sheet).
These acquisitions appear to be done at reasonable prices, and allow Rosetta Stone to reach expand internationally (Tell Me More is a French outfit) and into new adjacent product categories, namely "brain fitness" which is a growing category focused on increasing cognitive abilities later in life. And, in particular, Lexia Learning allows Rosetta Stone to leverage its language learning expertise, and expand its Enterprise & Education ("E&E") business by offering reading solutions for the K-12 segment, a natural adjacent to languages. Putting it all together, Rosetta Stone is diversifying its product offerings allowing it to offer attractive product bundles, and to leverage its marketing spend (which is high, and averaged between 50 and 60% of sales over the last three years).
In my view, the sell off in Rosetta Stone shares is overdone because in addition to Rosetta Stone's extensive brand value, it is also transitioning to a SaaS business model, particularly in its E&E segment, with significant recurring revenue and long lifetime customer relationships.
From recent conference calls, I understand that Rosetta Stone has north of 80% renewal rates for its large managed customer accounts in its E&E business. The SaaS business also has gross margins in excess of 80% (as does the consumer business), so Rosetta Stone has highly visible, sticky and high-margin recurring revenue streams. This is particularly important to the value proposition, and is the reason why SaaS businesses normally trade at premium multiples of sales.
Speaking of which, I understand the closest comparable transaction in this sector occurred in 2011, when Renaissance Learning was taken private for about 3.5x sales, after an unusual bidding process. Applying a 3x multiple to Rosetta's Stone E&E business (expected $80 million in 2013 sales), arrives at a value of $240 million for this segment alone (which should account for about one-third of total sales).
Turning to the consumer segment, Rosetta Stone reduced its cost structure by: (1) rightsizing its fixed cost base in its Asian operations and (2) abandoning its "zero calorie" revenue stream in the kiosk segment. To replace those sales, Rosetta Stone recently announced a strategic partnership with Target (NYSE:TGT), who will sell Rosetta Stone's product via 1,300 stores and through Target's online channels. While average revenue per user ("ARPU") may be reduced via wholesale channels, I think management made the right strategic move to shutter the kiosk channel which wasn't resulting in bottom line earnings growth.
So, while Rosetta Stone has considerable brand value and very high consumer awareness as a result of its marketing spend, Rosetta Stone only garners a ~$175 million enterprise value in the public markets today.
Because management is guiding to what appears to be an achievable $400 million in sales in 2015 at 10 to 13% operating margins, or $40 to $52 million in EBIT, Rosetta Stone looks cheap at the current price. If one assumes Rosetta Stone's pro forma operating profits land at $50 million, the company trades today for just 3.5 times pro forma 2015 EV/EBIT and 0.45x EV/sales. Both of those multiples are exceedingly low for a business of this nature.
Given that SaaS businesses with high renewal rates and rich margins similar to Rosetta Stone trade at premium sales multiples (between 2x and 5x, generally), there is plenty of room for error given the significant discount at which Rosetta Stone currently trades. In other words, management doesn't need to do anything heroic as part of its turnaround, other than execute the stated strategy and be mildly successful in integrating its four recent acquisitions, including Lexia Learning, Livemocha, Tell Me More and Vivity Labs.
Besides firm-level execution and integration risk, there is also risk to Rosetta Stone in the form of free alternatives that are emerging via digital channels. For example, massive open online courses ("MOOC's") pose a threat, but I think that language learning is a bit different than other subjects given languages generally need immersion and extensive practice for learners to become proficient. To that end, Rosetta Stone's solutions appear to offer better learner outcomes based on the curriculum and technology solutions that promote interactivity with instructors and other students, digitally.
Given the dynamics of the Rosetta Stone business model and the attractive industry to which it is levered, I am long these shares and I think they could be worth up to $20 today, equating to a ~$400 million market capitalization for the business.
At current levels, I think investors are incurring below average risks for above average potential rewards. In fact, if Rosetta Stone's share price stays low for another few quarters, I would argue this is a good thing, allowing the company to exercise the remaining $13.5 million in its share buyback program. It would also allow investors time to allocate capital to an idea that appears asymmetric to the long side at the current price.
Certainly integration and execution risk remains in Rosetta Stone's turnaround, given the change in distribution strategy and figuring out how to manage the new businesses acquired of late. Downside risk, though, should be mitigated due to a large net cash balance, a dwindling share count and the removal of a significant negative catalyst, namely, forced selling from PE investors.
Disclosure: I am long RST. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.