The good news: Rosetta Stone's
The bad news: As much as I like this small-cap company, I think its product is misaligned to the consumer market.
A bad case of sticker shock
I was interested in Spanish language tutoring software, and Rosetta Stone was the first product I investigated based on name recognition alone. I was shocked at the price, and I imagine my reaction is not unusual. I dug deeper and found something that concerned me more -- a bundled online subscription with an expiration date.
What happened to the product?
Rosetta Stone has one product, also called Rosetta Stone, available in more than 30 languages. The previous version, V3, was a complete "total immersion" language learning solution with three to five levels, depending on the language. One could purchase individual levels or sets. The level 1-3 set appears to be the most practical package for learning the basic language.
The new version, V4 TOTALe introduced in September 2010, is a bundling of the V3 product with new online services. The online components include live online lessons, a language-learner gaming community, and mobile access. The included online subscription lasts three to 15 months, depending on the package. The level 1-3 set lists for $579 and comes with nine months of online access. The full level 1-5 set is $749 and includes a 15-month subscription. These prices are 10%-20% higher than V3, depending on the bundle. The cost of extending online access is not published.
It's all about the operating income
As investors in potentially great companies, when we see a shift to a sustainable subscription revenue model, we get excited. Rosetta Stone introduced TOTALe prior to the holiday season, which is typically its biggest sales quarter. How did it do? Here are key data from the income statement:
|
Q4 2010 |
Q4 2009 |
Year Over Year (cash) |
Year Over Year (%) |
Effect |
|
|---|---|---|---|---|---|
| Product Revenue | $61,565 | $68,886 | ($7,321) | (11%) | Bad |
| Cost of Product | $9,507 | $9,330 | $177 | 2% | Bad |
| Subscription/Service Revenue | $12,715 | $9,425 | $3,290 | 35% | Good |
| Cost of Sub/Service Revenue | $2,819 | $959 | $1,860 | 194% | Bad |
| Sales and Marketing | $38,984 | $31,876 | $7,108 | 22% | Bad |
| Income From Operations | $2,585 | $18,769 | ($16,184) | (86%) | Very bad! |
Source: Rosetta Stone, 8-K Feb. 28, 2011. All dollar amounts in thousands.
Product revenues were down year over year. Marketing costs were up more than 20%. Increased subscription revenue was mostly offset by increased cost of generating that revenue.
It is unclear how the subscription portion of TOTALe translates into deferred revenue. Prior to the September launch, the company expected to defer 20%-25% of product revenue. The fourth-quarter statement shows $7.6M of added deferred revenue, implying 10%-15%, but the company did not provide specifics.
I am concerned about sales and marketing expenses, which jumped from 41% of revenues to 52%. That includes Web, magazine, radio, and television advertising, sales commissions, and office rentals in various countries. The expenses are not broken out by category. My own experience suggests that the ads serve primarily to keep Rosetta Stone's name uppermost in consumers' minds, but it's fair to ask if 52% is excessive.
Rosetta Stone has respectable free cash flow, even if down this year because of the poor quarter ($23.4 million in 2010 vs. $32.7 million in 2009). Any improvement in revenue coupled with reduced marketing costs would dramatically improve cash flow.
Product Alignment 101
While the online features seem cool and useful, I believe it makes sense for Rosetta Stone to rethink the strong coupling between the original "total immersion" product and the new online component, reduce the price to generate a higher conversion rate, and be more judicious about marketing.
Rosetta Stone says it is trying to reposition sales so there isn't so much reliance on consumers. I would argue that companies and educational institutions are being just as careful about software outlays, particularly where recurring costs are involved. Hey, I work for a public university in my day job, and it's hard enough just to scrounge office supplies. We rarely purchase anything retail -- we often buy the same product with an "academic use only" sticker at 50%-75% off list.
There is tremendous potential to a Rosetta Stone investment, but it needs to be recognized that the company is small and isn't going to go toe-to-toe with the big education publishers like McGraw-Hill
Your investment will pay off only if Rosetta Stone can match its products to its customers' needs at a price point that will stimulate sales.
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