Rosetta Stone: Sees Profits Once Again In Coming Future

Summary

• Rosetta Stone is successfully transforming into a simpler and more profitable business.
• Rosetta Stone will continue to embrace higher overall profit percentages as the transition is finalized.
• Rosetta Stone is a good long term opportunity for growth seeking investors.

Thesis:

Rosetta Stone (NYSE:RST) is successfully transitioning into a lower cost, higher profit margin business model. By electing to phase out of the consumer product segment and shift towards educational subscription services, RST will soon be positioned for high revenue growth and positive earnings. (See the 10-K for reference.)

Introduction:

Rosetta Stone is widely respected for its highly effective instructive language learning software. After Q4 of 2015, RST celebrated the achievement of growing its educational subscription segment to greater than 50% of the overall company in terms of revenue. This major milestone was significant because it was the long term vision of management and the highest profit margin segment of the company. Now that the transition process is more than half way complete, RST and investors can expect to begin seeing improved financials in the upcoming quarterly reports, and greater value creation from less invested capital. As the business transition continues its course, RST will enjoy a long period of steady growth and higher profitability.

Consumer Product Segment

The consumer product segment was once a profitable operation until it became heavily dependent on marketing in order to sustain consistent growth. The major problem was that product sales were one time transactions that required a new buyer every time. The isolated costs associated only with this segment are manufacturing, packaging, storing inventory, and shipping. These costs were affordable and offset by high product prices but this only added to the growing difficulty RST was having maintaining positive sales growth. Management realized that this segment was becoming unmanageably expensive to promote, and decided to stop spending the extremely high capital on sales and marketing expenses for product sales. Instead, Rosetta Stone made the decision to phase out of product sales and move towards a virtual education subscription service company. The breakdown below shows the product consumer segment in the last 5 years, its diminishing percentage of the total business, and its lack of profitability from costly marketing and advertising expenses.

All #'s are in millions)	[From: Capital IQ]
RST Product Segment Analysis	2011	2012	2013	2014	2015
Consumer Product Revenue	195.40	180.90	156.40	136.30	66.00
Segment % of Total Business Rev.	73%	66%	60%	52%	30%
Consumer Product COGS	-49.10	-48.90	-45.70	-53.10	-17.00
Segment Profit	146.30	132.00	110.70	83.20	49.00
Total (M&A + G&A) * Segment %	170.00	140.00	123.00	120.00	54.00
Total Profit	(23.70)	(8.00)	(12.30)	(36.80)	(5.00)

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The consumer product segment has created consistent losses over the past 5 years, however finally represents less that 30% of the overall company. This operational shift to a subscription service business is helping RST lower overall expenses by decreasing the need for high marketing efforts. Over the course of 2016, Rosetta Stone will continue to remove the product segment entirely until it no longer exists. The subscription service segment will then take over as the controlling driving factor of the company.

Electronic Subscription & Service Segment

Rosetta Stone is currently more than 70% controlled by its subscription service segment as of the end of 2015. This segment allows for an entirely virtual business model with downloadable products and lower COGS. After the transition is complete, RST will no longer be responsible for manufacturing hardware, packaging CD's, holding storage, or shipping. Business virtualization will increase overall profit margins, and subscription pricing models are creating reoccurring revenue opportunities. Rosetta Stone's Lexia Learning software has received very positive feedback by language programs in many school districts across the country, and has positioned RST for long term growth in this market. The focus on education programs in schools decreases excessive advertising expenses, and simplifies ongoing sales by partnering with schools that annually re-subscribe for Rosetta Stone's interactive language learning software. The education market is more focused, and easier to effectively advertise to than trying to mass market to all consumers on the planet. The breakdown below shows the subscription service segment in the last 5 years, its takeover progression as a percentage of total business revenue, and the higher profitability of the virtual and simpler electronic subscription service segment.

(All #'s are in millions)	[Data From: Capital IQ]
Electronic Subscription Segment Analysis	2011	2012	2013	2014	2015
Subscription & Service Revenue	73.1	92.3	107.9	126	151.7
Segment % of Total Business Revenue	27%	34%	40%	48%	70%
Subscription & Service COGS	-12.6	-15.2	-13.5	-18.9	-21.6
Segment Profit	60.5	77.1	94.4	107	130.1
[Total (M&A + G&A)] x (Segment %)	-59.4	-69.7	-80	-107	-122.5
Total Profit	1.10	7.40	14.40	0.00	7.60

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The electronic subscription segment has higher profit margins and lower associated marketing expenses that enable it to remain a profitable business segment every year. This segment has posted consistent revenue growth dating all the way back to 2005 and will continue this trend for many years ahead. Lexia is Rosetta Stone's top performing language education software right now. With over a 90% retention rate for new trial users, and a 50% revenue growth in 2015, RST estimates continued growth in this division which will help foster overall growth in the subscription service segment. RST and investors will also enjoy growing profit margins while the costly product segment continues to fully phase out of the company. This transition will begin having a positively dramatic effect on earnings growth in upcoming quarters.

Looking Forward to 2016

2016 will be the pivot point for investors and RST to begin benefiting from the success of simplifying operations and reducing unnecessary costs throughout the company. Management projects that total revenue will continue to decline for the first quarter of 2016 in line with expectations as a result of further reduced sales in the consumer product segment. Electronic education subscription service revenue was also forecasted to slightly decline from managements decision to strategically exit a select few unprofitable locations. These decisions will allow RST to continue drastically decreasing operating expenses, and will position the company for a period of long term high profitable growth. In 2016, the accumulated cost savings will be the dominating value driver for the company. Look for Rosetta Stone to complete its strategic shift by the end of 2016, and embrace higher profit segments and overall revenue growth in 2017.

Risks for Investors to Consider

1) Low Possible Competition

An up and coming language learning competitor, Babbel, originated in Germany and soon will be entering America's market. Babbel's biggest advantage is its low cost pricing strategy with subscription packages starting as low as $7.45 per month. The affordability and strong reputation the company has already built in Germany may translate to positive sales in the consumer market of the United States. Fortunately, Rosetta Stone is no longer relying on consumer sales for its main revenue stream and this will lessen the impact that Babbel can have.

Discontinuing the consumer segment is also helping RST avoid the threat of competition from free language learning software. The transition to a higher focus on education markets helps remove a lot of competitors who focus on public consumer sales. As Rosetta Stone continues completing its transformation, consumer segment competition will become less of a factor. However, competition in the education market will have a greater impact for the future of the company

2) High Possible Competition

A major competitor for Rosetta Stone in the enterprise & education segment is Duliongo. Duliongo has also been successfully expanding its business in education programs in various school districts. RST and Duliongo are two of the top players in this market and are proving to have successful programs. This competition will make it more difficult for RST to maintain positive growth for its E&E segment in the long run. This factor is an uncertainty that investors should consider if taking a long position on the company.

Additional Notes

1) Insider Ownership

The public ownership shown above from capital IQ reveals high Institutional and Hedge Fund interest. In the past 12 months, insider have accumulated almost 280,000 purchases and sold only 12,608 shares. This activity is related to the success RST is having strategically shifting its operations, and great sign that it is going continue in 2016 as well.

2) Declining M&A and G&A

(Data from Capital IQ) Total M&A + G&A ( #'s in millions)
2011	2012	2013	2014	2015
223	206	201	229	178

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Total advertising/marketing and general/administrative expenses have been decreasing over the course of the operational shift. RST is becoming a more cost effective company, able to avoid unnecessary expenditures by focusing growth strategies. This trend will continue as the consumer segment continues to be phased out of Rosetta Stone's overall business model.

3) Deferred Revenue

Rosetta Stone currently has 139.4 million dollars in deferred revenue and plans to recognize 102.7 million of it over the next 12 months. This incoming revenue will help compensate for the declining product segment and boost overall revenue for all of 2016.

Conclusion

At the current price, I believe Rosetta Stone is the right investment for any long term growth investor looking for a high return. RST is successfully transforming its business, and pursuing only profitable strategies that benefit from low cost operations. The subscription service segment, also known as the enterprise and education segment, is becoming the sole driving factor for RST's future. Using a proforma to discount future cash flows by assuming an annual 5% decline in the subscription segment (strategic discontinuation of unprofitable divisions) , including 100% of the proposed deferred revenue, and eliminating the consumer product segment, I calculate an intrinsic value of $7.69 and a 1 year price target of $10.50 for RST. This represents a 35% return and a great opportunity for investors to benefit from a currently undervalued company.

Disclosure: I am/we are 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.