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Investors should always develop a thesis on the stocks they buy. Seven weeks ago, I published an article arguing that Rosetta Stone (NYSE: RST ) was maturing into a winner. Given its recent earnings release, and a share-price drop of more than 15% in the following days, I think now is a good time to revisit my thesis.
Reasons for buying
- Rosetta was transitioning to a subscription model with its Version 4 Totale. Version 4 came to the market on Sept. 14, so it had only two weeks on the market before the end of the third quarter. Subscriptions, however, still contributed $11.5 million in revenue and accounted for 19% of total revenue. I see subscription revenue continuing to increase moderately in future quarters.
- The company would be enduring short-term losses for long-term gains. There were no real surprises here. Rosetta Stone spent $1.6 million in sales and marketing to promote the launch of Version 4. Though I'm optimistic about Version 4's potential, only time will tell whether long-term value is being created.
- International sales were accelerating at a huge clip. This was probably the most encouraging part of the earnings release. International sales increased by 119% from the same period last year, yet international revenue still makes up only 17% of Rosetta's total revenue. This is a very encouraging set of figures, when you consider that the desire to learn English represents Rosetta's biggest market opportunity.
- Institutional buyers were growing and diversified. Institutional growth was the most disappointing aspect of the earnings release: It grew at 12% year over year. But institutional weakness isn't limited to Rosetta Stone: Cisco (Nasdaq: CSCO ) announced that a massive drop-off instate and local government spending was a leading cause of plummeting demand. Dell (Nasdaq: DELL ) followed up with earnings that were generally very positive, with the sole blemish being state and local government spending well below the rest of its business.
However, in Rosetta's case, I think that part of the weakness in institutional growth has to do with the poor timing for the release of Version 4. Many institutions, knowing that a new version would soon be released, probably waited for Version 4. I consider schools to be one of the biggest institutional buyers for Rosetta. Schools need their budgets to be set before the year begins, so we'll have to wait a full year, until the third quarter of 2011, to see how interested the educational sector is in committing to the company. A March/April release of Rosetta's newest product would have been a much wiser release date.
I think the market had reason to worry about Rosetta's lowered guidance for the fourth quarter. Even though this report includes only numbers for two weeks of Version 4 on the market, management has an inside track into how well it has been selling since.
However, the company has made a standard practice of underpromising and overdelivering. In the third quarter, analysts had predicted an adjusted $0.06 loss in earnings per share, and in reality, Rosetta lost only $0.02 per share.
In the end, I think the market is offering a buying opportunity for those of us with a long-term horizon. My spouse and I recently purchased all five levels of the Latin American Spanish program, and we have been very pleased with the results. As I stated in my original article, Rosetta is going through growing pains, and faith in the company's ability to grow and innovate could enrich investors in the years to come.
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Want to read more about Rosetta Stone? Add it to My Watchlist, which will find all of our Foolish analysis on this stock.