What: Language education software company Rosetta Stone Inc's (NYSE:RST) stock was up 9.2% at 12:50 p.m. Thursday after the company reported third-quarter earnings after the market closed on Nov. 4. The company still reported a net loss in the quarter and sales were down more than 20% from last year, but the drop in sales was largely a product of a major shift in focus, and the loss was expected as a result of the strategic shift. 

In other words, Mr. Market was expecting things to be worse. So bad looks good when it's actually "less bad" sometimes. 

So what: Rosetta Stone's business has languished for years on weak sales of its core foreign language product, even with significant investments in marketing and web- and app-based options designed to improve sales. So over the past year or so, management has made a concerted effort to focus the business on its growing Education and Enterprise (E&E) segment, versus the stagnant consumer market, while also significantly reducing expenses. 

So far it looks like those efforts are paying off. E&E sales increased 12% in the quarter, largely due to the more-than-doubling of sales of its Lexia language products. E&E sales made up more than half of total sales in the quarter, due to the increase, as well as a 40% drop in consumer foreign language revenue. However, major cost reductions in the consumer segment increased contribution margin from 17% last year to 27% this quarter. In short, management has acknowledged that growing this segment has proven difficult, so better to "right-size" the company's business and be profitable, versus fighting to grow in a weak demand environment. 

Total operating expenses came in more than 25% lower in the quarter, driven by the reduction in sales and marketing expense in the consumer segment. 

Now what: Rosetta Stone cut its losses in half in the quarter, but is still losing money. The company carries no debt, but its capital position did weaken over the past year. Rosetta Stone's cash position and accounts receivables (moneys it expects to collect from customers) fell nearly $60 million over the past year. In other words, the $4 million increase in cash from the second quarter that the company reported, was a change in working capital, not free cash flows. 

With that said, the combination of cost cuts, refocusing on improved margins in the consumer business, and investing in growth in the E&E segment (that's actually growing) looks to be paying off, as losses fell from $16.1 million last year to $7.3 million in this year's Q3.

If the company continues to execute on this leaner approach to consumer software, and investing in growth in E&E, profits could be just around the corner. The progress has been solid, but there's still a lot of work to be done.


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