David's Stock No. 1

Rosetta Stone

If you had a strong desire to learn Portuguese, you could spend some time in Mozambique, try to find a course at your local community college, immerse yourself in a Berlitz class, or pick up the yellow box from Rosetta Stone [NYSE: RST]. The company has built a strong reputation for teaching new languages relatively painlessly and affordably, making it the brand-name leader without rival. As David says, "I can't find the Pepsi to Rosetta Stone's Coke. There's no comparable competitor."

That's a large part of the reason David feels the company -- which shoots to make learning a language fun, easy, and effective -- has the potential to be a 10-bagger. It shares many of the characteristics of some of David's very best recommendations, specifically:

• It has a purpose and a mission that is important and relevant.
• It is an undisputed leader in its field.
• It has created a brand and identity that resonates directly with consumers.

The company started with an idea and developed an innovative solution. Instead of parsing sentences, conjugating verbs, and memorizing vocabulary lists, users of Rosetta Stone software -- of which there are millions -- learn through something the company calls dynamic immersion, which incorporates images, text, and sounds to teach using the natural language learning ability we had as kids.

Just Getting Started

And the nineteen-year-old company would seem to have its greatest opportunity ahead of it. It's just starting to develop its international presence, even though the United States accounted for only $2 billion of the $32 billion spent worldwide in 2007 in an attempt to learn a language through self-study.

With an average sales price of $355, Rosetta Stone's software makes learning a foreign language relatively affordable for motivated learners, but it still carries a high gross margin north of 80%. With that kind of margin and strong organic growth potential -- both internationally and domestically in what remains a relatively fractured market -- Rosetta Stone should be able to grow profits as it gains scale.

Additionally, its innovative origins remain today as the company constantly seeks to build features that allow it to make the learning process easier, more fun, and more accessible for its lovers of language. While Berlitz stretches only as far as audio CDs, a Rosetta Stone package of Level 1 and 2 Portuguese -- retailing for $399 and designed to build intermediate-level conversational skills -- comes with interactive software, an audio companion for your MP3 player, a headset and microphone for use with its speech recognition software, live online sessions, games, access to its community, and a mobile companion for learning on an iPhone or iPad Touch. The idea behind the product extensions -- a subscription model the company tags Version 4 Totale -- is to build more engaging and longer-term relationships with its customers.

What's Not to Like?

But not everything is sol e pirulitos (sunshine and lollipops in Portuguese) for Rosetta Stone. The company, which went public in April 2009, took a hit later that year when it canceled a secondary offering and lowered earnings guidance, citing ill-spent sales and marketing costs and higher-than-expected product development expenses -- not exactly the quick jump off the public starting blocks that analysts like to see.

More recently, the company's CFO resigned, and the COO followed him out the door, raising some questions in David's mind about Rosetta Stone's culture. While he likes CEO Tom Adams (who has been running the company since 2003 and is still under 40), David wants to see a sense of stability and maturity among the leadership, along with a shift away from its unfortunate approach of overpromising and under-delivering on its financial results.

Rosetta Stone's business is growing, though.

What's more, with a vast advantage in brand recognition, an evolving business model that appears to be paying off on two significant fronts, and a world of people who want to communicate with more people than they can in any one language, Rosetta Stone has the look of a long-term, big-time winner.

Catalysts

• Keep an eye on turmoil in the management suite. Two high-profile departures make a line, three could indicate a trend.
• Monitor the progress of international and subscription services -- the company has plotted a big chunk of its future on these bets, so make sure the growth continues on both fronts.
• Management has made a habit of disappointing the market, and its stock performance has been whiplashed as a result. There's a reasonable chance that shares will take another hit at some point, which could present a buying opportunity for what remains, despite management missteps, an outstanding business.

Watching on the way up

Which brings us to...