The growth potential of Rosetta Stone's (NYSE:RST) B2B segment is not fairly reflected in its valuations and share price. Its B2B segment operates on an attractive recurring revenue SaaS (Software as a Service) subscription business model, with renewal rates in the range of 75%-80%. Applying a 3x EV/Revenue to Rosetta Stone's end-2014 estimated bookings of $115 million for its B2B segment and adding an estimated year-end net cash of $65 million, my target price for Rosetta Stone is $19.30, representing an upside of 92% from its share price of $10.04, as of December 9, 2014. Osmium Partners' activist stance and appointment of a director to Rosetta Stone's Board should lead Rosetta Stone's management on the path of shareholder-friendly, value-accretive actions.
Rosetta Stone provides innovative, technology-driven learning solutions to both B2C (individuals) and B2B (schools, businesses, and government organizations) customer segments. Within the technology-based learning industry, Rosetta Stone participates in the consumer and institutional language learning, literacy and reading for students, brain fitness and kids-focused learning solutions categories.
Transformation Started Since 2012 Led To Growing B2B Revenues
In early 2012, Rosetta Stone was largely a B2C company focused on one core product, technology-driven language learning solutions, which was mainly sold in physical boxes. This meant that Rosetta Stone suffered from several problems. Firstly, Rosetta Stone didn't capitalize on the adjacent growth opportunities in technology-driven learning such as literacy, reading and brain fitness. Secondly, it ran the risk of becoming obsolete, as consumer buying and consumption habits shifted from offline to online. Lastly, its revenues were lumpy, as it relied on one-time sales of its products. In February 2012, Stephen M. Swad was promoted from CFO to CEO and he led Rosetta Stone's transformation.
Rosetta Stone expanded beyond its core language learning business and diversified into education-technology with its acquisitions of Livemocha (among largest online language-learning communities globally) and Lexia Learning Systems (reading technology) in 2013, and Vivity Labs (sells Fit Brains brain-training products) and Tell Me More (language-learning software company with significant presence in Europe) in 2014. In addition, Rosetta Stone started to generate more online sales of its language learning solutions.
More importantly, Rosetta Stone's B2B segment, which it terms as Enterprise & Education, has grown much bigger and stronger, following its efforts to strengthen the product portfolio in 2013 via acquisitions. Its B2B customers include K-12 schools, businesses, and government organizations. Rosetta Stone's Enterprise & Education business segment has increased bookings from $61 million in 2012 to $75 million in 2013, and it expects bookings to further grow to $115 million in 2014, representing a year-on-year growth rate of 53%. This is highly achievable, as its cumulative bookings for the Enterprise & Education business segment in the nine months ended September 30, 2014 already account for 73% of its full year guidance of $115 million in bookings. Note that bookings represent executed sales contracts received by Rosetta Stone that are either recorded immediately as revenue or as deferred revenue.
Rosetta Stone's Enterprise & Education business segment boasts significantly more attractive economics than its legacy one-time sale B2C business model. Its Enterprise & Education business segment generates substantially all of its sales from a SaaS (Software as a Service) subscription business model, with renewal rates in the range of 75%-80%. Furthermore, the future growth prospects look very promising, particularly in the areas of K-12 education, basic literacy training and language learning. According to a study conducted by IBIS Capital in January 2013, e-Learning expenditure for K-12 education is projected to grow at a 33% CAGR between 2012 and 2017; while 0.7 billion adults are expected to lack basic literacy skills by 2015; and the English language learning market is currently valued at $36 billion and expected to grow at a 25% CAGR going forward. Rosetta Stone's ability to deliver a complete suite of solutions from basic literacy to advanced language proficiency to both kids in schools and working adults in corporates, should position it for the tremendous future growth opportunities.
Instead, investors are unfairly penalizing Rosetta Stone for the lackluster performance of its B2C business segment. For the nine months ended September 30, 2014, its B2C segment's bookings have declined by 9.8% year-on-year to $128 million. While I expect Rosetta Stone's core B2C language-learning solutions business to continue being impacted by free online technology-driven language solutions such as apps, any such decline should be partially offset by the increased revenues from cross-selling of new products. For example, Rosetta started to up-sell its brain-training solutions branded Rosetta Stone Fit Brains to its existing customers signed up for language-learning solutions in the third quarter, with cross-selling penetration rates at approximately 5%.
Publicly traded SaaS companies trade anywhere between 4 to 20 times EV/Revenue, while they have historically been valued at a range of 3-5 times EV/Revenue between 2004 and 2011. If I apply a 3x EV/Revenue multiple to Rosetta Stone's 2014 estimated bookings of $115 million for its B2B or Enterprise & Education business segment and add its end-2014 estimated net cash balance of $65 million, I arrive at a target price of $19.30 for Rosetta Stone. This represents a 92% upside from Rosetta Stone's share price of $10.04, as of December 9, 2014. More importantly, this target price does not even ascribe any value to Rosetta Stone's B2C business which delivered bookings of $128 million (or approximately $6 per share) for the first nine months of the year.
The key catalyst for Rosetta Stone is the adoption of the action plan proposed by Osmium Partners, an asset management firm. In August this year, Osmium Partners changed its filing status for its then 9.95% stake in the Company from passive to activist. In November, it was disclosed that Osmium Partner has increased its stake in Rosetta Stone to 10.67%. On November 19, 2014, Rosetta Stone appointed Arthur "John" Hass to the company's board of directors. Hass was formerly senior advisor at Osmium Partners and boasts more than two decades of experience serving the roles of investment banker, CEO, and director. This is part of a standstill agreement between Rosetta Stone and Osmium Partners, where Osmium Partners is not allowed to conduct a proxy contest during the period of the standstill agreement.
Osmium Partners disclosed a four-point action plan, proposing the following actions for Rosetta Stone. Firstly, Rosetta Stone should take actions to double targeted free cash flow margins to 4% in 2015, Secondly, Rosetta Stone should "create a sharp focus with a clear strategy" to grow both the B2B and B2C segments. Thirdly, Rosetta Stone should "provide clear disclosures and appropriate business metrics for shareholders." Lastly, Osmium Partners urged Rosetta Stone to buy back its own shares aggressively.
If Rosetta Stone adopts some or all of Osmium Partners' proposed actions, it should accelerate the narrowing of the gap between Rosetta Stone's share price with its underlying intrinsic value.
The biggest risk with Rosetta Stone is its reliance on language-learning solutions for its B2C segment. Free language-learning solutions and decline in international travel are some of the factors that could negatively impact Rosetta Stone's B2C segment, if it does not diversify into new products outside its core language-learning solutions effectively.
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