Consumer sales were less than half of revenue, and that's probably a good thing. Source: Rosetta Stone.

Rosetta Stone Inc. (NYSE:RST) reported third-quarter earnings on Nov. 4, and something was very different. Sales of the company's flagship Rosetta Stone foreign language software made up less than half of sales for the first time ever. Chances are, it won't be the last, either. 

Over the past couple of years, Rosetta Stone management came to the realization that there just wasn't enough sustained consumer demand for its foreign-language programs to make them a big source of growth. The company had tried numerous approaches, ranging from the yellow boxes at kiosks in malls, to heavy online marketing, to app-based versions with monthly costs, versus the big sticker-shock prices for the PC software package. 

This quarter's results -- while mixed -- indicate that the company's steps to move beyond just a foreign language learning company may be paying off. 

The numbers 

 MetricQ3 2015Q3 2014Change
Revenue $49.8 million $64.5 million (22.8%)
Net income ($7.3 million) ($15.6 million) 47%
Earnings per share ($0.34) ($0.76) 45%

A closer look at what happened in the quarter 
Those results are pretty awful on the surface, with a big drop in total sales and a pretty wide loss, even if it's smaller than last year's third quarter. Here's a little broader context on the company's operating results.

  • The sales decline was due to a huge 42% drop in consumer revenue. Enterprise & Education revenue increased 12%. Sales of Lexia, a key product for the education market, increased 103%, and bookings of Lexia grew 72% in the quarter. Education made up more than half of E&E sales because of Lexia's strong growth. 
  • Operating expenses fell 26%, with significant reductions in sales and marketing expense, down 31%, as well as R&D and general/administrative expenses, which declined 18% each. These cuts are all tied to reducing the investment in the consumer foreign-language software, in which the company has failed to get sustained growth for years, despite increased marketing investments. 
    • The results (at least so far) indicate that the company is making the right call. 
  • Rosetta Stone reported a GAAP net loss, but CFO Tom Pierno said the company generated $5.2 million in free cash flow in the quarter, up from $3.4 million in last year's Q3. That's a huge improvement from the $16 million negative free cash flow reported in the second quarter. 
  • Cash and equivalents increased $4.6 million to $34.3 million. 
  • Deferred revenue increased significantly, because of the increase in bookings. This metric is shown as a liability on the balance sheet, but it's a major source of future business. Deferred revenue of $102.7 million will be recognized revenue over the next 12 months. This is one "liability" that's good to see grow. 

What management said 
CFO Tom Pierno spoke on the revenue decline, and how management expected a falloff in sales of Rosetta Stone language software to consumers: "GAAP revenue was $49.8 million in the quarter, down $1.6 million sequentially and down $14.7 million year over year. These decreases were driven by the expected decline in consumer segment revenue."

Interim CEO John Haas touched on the immediate benefits of a leaner consumer segment that's focused on profits, versus overspending for growth that never materialized: "I'm pleased that for the second quarter in a row, Philip Dunne and the team that oversees our consumer language learning products increased the segment contribution margin percentage by over 50% year over year, delivering a 27% margin in the third quarter of 2015, up from 17% in the same period in 2014."

Haas also talked about opportunity to continue strong growth in the education segment -- particularly the value of Lexia: "Overall, we now expect Lexia to have full-year bookings in the low $30 million range in 2015, which is almost double the run rate when that acquisition was completed just over two years ago. And we continue to believe Lexia can nearly triple to be $100 million bookings business with healthy margin in four to five years."

What's next? 
In less than a year, Rosetta Stone's management -- and under an interim CEO, no less -- has sharply turned the company in a different trajectory. The legacy Rosetta Stone foreign-language software remains a core part of the business, but after years of failed attempts to grow it, the company has moved beyond heavy spending that didn't lead to sustainable growth. 

The Education and Enterprise business, however, has shown the capacity for growth, with a base of corporate, government, and learning institutes willing to pay for the company's top-notch learning products. While the turnaround isn't complete, Rosetta Stone has made significant progress. 

Can the company sustain its rate of growth in the E&E segment, stabilize sales to consumers, and continue its efforts at expense control? If so, that bodes very well for Rosetta Stone shareholders. 

 

Jason Hall has no position in any stocks mentioned. The Motley Fool recommends Rosetta Stone. 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.