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

  1. 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.
  1. 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.
  1. 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.
  1. 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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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.