September 27, 2010
When I was in fifth grade, a girl named Sarah Williams asked me to be her boyfriend. She was awkward and had braces; I said no. When she graduated eight years later, she was the bombshell every guy wanted. My mistake: not appreciating that everyone has awkward growing pains.
I thought of Sarah when Rosetta Stone (NYSE: RST ) released its Version 4 TOTALe last week. Though the company, which just went public in April of 2009, has gone on a recent run-up in price, Rosetta is still trailing its summer highs by about 20 percent -- and it has plenty of room to grow.
First, why are investors worried?
Rosetta's second-quarter release offered plenty of reasons to panic in the short term:
- A second C-level executive announced he was leaving the company (after an earlier departure by the CFO).
- Though it crushed earnings expectations by 30%, Rosetta missed on revenues by about 8%, and guidance for the third quarter shows the company losing money.
What everyone should have been paying attention to ...
A key to great investing is to ignore the short-term noise and focus on the broader horizon. There were several pieces of information from the last quarter that should get us excited about owning this stock eight years from now (and not repeating the same mistake I made when I was 11).
- With the release of Version 4 TOTALe, Rosetta is taking steps to transition from a base of one-time buyers to lifetime subscribers, ensuring a steady stream of cash. This essentially mimics one advantage Netflix (Nasdaq: NFLX ) had over Blockbuster, ultimately beating the latter into bankruptcy.
- The company is willing to endure short-term losses for long-term gains. It will be spending its cash to hire real-time language support coaches. This unique offering will be expensive, but will add value and help differentiate Rosetta from possible competitors.
- International sales accelerated at an enormous clip: 155% year over year. This represents a huge area for growth as international sales currently account for only 14% of total revenue.
- Institutional buyers are growing and diversified. Sales to institutional buyers grew 25% last quarter, year over year. These buyers come from the ranks of K-12 education, the Department of Defense, and multinational corporations, among others.
By bracing ourselves for some growing pains along the way, Rosetta Stone investors could be richly rewarded in the future.