Are Shorts Watching Rosetta Stone?

There's no foolproof way to know the future for Rosetta Stone (NYSE: RST  ) or any other company. However, certain clues may help you see potential stumbles before they happen -- and before your stock craters as a result. Rest assured: Even if you're not monitoring these metrics, short-sellers are.

A cloudy crystal ball
I often use accounts receivable (AR) and days sales outstanding (DSO) to judge a company's current health and future prospects. It's an important step in separating the pretenders from the market's best stocks. Alone, AR -- the amount of money owed the company -- and DSO -- days worth of sales owed to the company -- don't tell you much. However, by considering the trends in AR and DSO, you can sometimes get a window onto the future.

Sometimes, problems with AR or DSO simply indicate a change in the business (like an acquisition), or lax collections. However, AR that grows more quickly than revenue, or ballooning DSO, can also suggest a desperate company that's trying to boost sales by giving its customers overly generous payment terms. Alternately, it can indicate that the company sprinted to book a load of sales at the end of the quarter, like used-car dealers on the 29th of the month. (Sometimes, companies do both.)

Why might an upstanding firm like Rosetta Stone do this? For the same reason any other company might: to make the numbers. Investors don't like revenue shortfalls, and employees don't like reporting them to their superiors.

Is Rosetta Stone sending any potential warning signs? Take a look at the chart below, which plots revenue growth against AR growth, and DSO:

Source: Capital IQ, a division of Standard & Poor's. Data is current as of last fully reported fiscal quarter. FQ = fiscal quarter.

The standard way to calculate DSO uses average accounts receivable. I prefer to look at end-of-quarter (EOQ) receivables, but I've plotted both above.

Watching the trends
When that red line (AR growth) crosses above the green line (revenue growth), I know I need to consult the filings. Similarly, a spike in the blue bars (DSO) indicates a trend worth worrying about. As another reality check, it's reasonable to consider what a normal DSO figure might look like in this space.

Company

LFQ Revenue

DSO

 Rosetta Stone $61 60
 McAfee (NYSE: MFE  ) $523 46
 Oracle (Nasdaq: ORCL  ) $7,502 57
 Microsoft (Nasdaq: MSFT  ) $16,195 64

Source: Capital IQ, a division of Standard & Poor's. DSO calculated from average AR. Data is current as of last fully reported fiscal quarter. LFQ = last fiscal quarter. Dollar figures in millions.

Differences in business models can generate variations in DSO, so don't consider this the final word -- just a way to add some context to the numbers. But let's get back to our original question: Will Rosetta Stone miss its numbers in the next quarter or two?

Investors should watch the top line carefully during the next quarter or two. For the last fully reported fiscal quarter, Rosetta Stone's year-over-year revenue shrank 9.4%, and its AR grew 14.7%. That's a yellow flag. End-of-quarter DSO increased 26.6% over the prior-year quarter. It was up 42.4% versus the prior quarter. That demands a good explanation. Still, I'm no fortune teller, and these are just numbers. Investors putting their money on the line always need to dig into the filings for the root causes and draw their own conclusions.

What now?
I use this kind of analysis to figure out which investments I need to watch more closely as I hunt the market's best returns. However, some investors actively seek out companies on the wrong side of AR trends in order to sell them short, profiting when they eventually fall. Which way would you play this one? Let us know in the comments below, or keep up with the stocks mentioned in this article by tracking them in our free watchlist service, My Watchlist.

Seth Jayson had no position in any company mentioned here at the time of publication. You can view his stock holdings here. He is co-advisor of Motley Fool Hidden Gems, which provides new small-cap ideas every month, backed by a real-money portfolio. Microsoft is a Motley Fool Inside Value selection. Rosetta Stone is a Motley Fool Stock Advisor pick. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Microsoft, and Oracle. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On December 03, 2010, at 2:36 PM, JMB711 wrote:

    I think one thing you have to be careful with when you compare sales and AR is to also consider the business and customer base. Certainly consider the cyclical nature of retail sales. However, also consider that RST sells to a wide variety of customers (individuals, institutions, international). Institutional sales will be more likely in the early fall (consider state and federal budget approval processes). Finally consider the nature of the product that is being sold. RST sells a large number of licenses to institutional customers which are 1 year subscriptions (or more). The full price is probably due up front but the revenue would be recognized over the term of the subscription. Certainly all of these factors create uneven sales, outstanding AR and collection patterns. Comparing year over year trends will be more telling than quarter over quarter trends.

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