Description

Summary and Thesis:

At current levels, we believe that Rosetta Stone (NASDAQ: RST) represents a highly compelling risk/reward.

RST is composed of 3 businesses:

-         K-12 Literacy (Lexia)

-         Enterprise and Education Language (E&E)

-         Consumer Language (CL)

While RST remains best known for aggressively-advertised language learning CDs, RST no longer sells CDs. Rather, RST’s most valuable business is Lexia, an education technology software company focused on K-12 literacy. We believe that the market does not appreciate the value that RST has created through this business and that Lexia alone is worth more than RST’s market price. As a result, we are getting RST’s language business – a 100% subscription software business that generates $130mm of high margin revenue – for free.

RST is led by highly competent, trustworthy, and manifestly shareholder aligned management.

Accordingly, we believe RST offers a mispriced opportunity where fundamental downside is minimal and fair value is 50%-100%+ above current levels. We expect to realize value as the Company continues to execute on its stated goals or the Company is acquired by a strategic or financial acquirer.

K-12 Literacy (Lexia):

Lexia is an education technology company focused on adolescent literacy. Lexia’s primary product is Core5, aimed at K-5 students, but the Company recently introduced PowerUp, a product aimed at grades 6-12. Lexia also has a separate reading assessment product (RAPID Assessment).

In researching Lexia, we spoke with educators, researchers at non-profit institutions who assess Ed-Tech products, competitors, formers, and industry participants of various stripes. The summary upshots are that Lexia is the most data driven product on the market, teachers love it, and it has a long runway for further penetration. Most importantly, it actually teaches kids how to read.

Lexia is sold on a subscription basis and the vast majority of subscriptions are for 1 year periods. For 2018, RST is forecasting sales (bookings) of ≈$60mm, up 25%+ vs. 2017. RST’s 2020 sales target is $100mm.

Lexia has the ability to generate 30-40% steady-state profit margins, a number we have confirmed with multiple private players in the Ed-Tech space. But so long as Lexia can continue its strong growth, the Company will continue to invest aggressively into sales & marketing.

Based on discussions with industry participants and bankers as well as analysis of relevant transactions, we believe that Lexia would have no problem garnering a 5x bookings multiple and something in the 7x-8x range is eminently reasonable.

Accordingly, RST’s current EV is covered by valuing Lexia at 5x run-rate bookings. At a 5x-8x on projected 2020 sales, Lexia is worth $22-$35/share.

Education & Enterprise (E&E):

RST’s E&E business sells language learning software to two distinct markets:

-         Education – primarily serves the US K-12 market with roughly half the business dedicated to the ESL market

-         Enterprise – serves global corporations requiring language learning services for their employees

Although both businesses have experienced declines over the last few years, we believe prospects looking forward are much brighter.

Education should start to benefit from the Company’s planned introduction of an ESL reading product (essentially a bridge product between Education and Lexia). As it stands, Education is the only segment/sub-segment in which RST has not made material product investments over the last few years.

Adjusted for exited regions, Enterprise product has already stabilized / returned to modest growth. Enterprise is just now starting to really benefit from the late 2016 introduction of Catalyst, RST’s wholly revamped product for the enterprise market.

Moreover, the Company has recently made a series of hires focused on the E&E business, a sign that management believes the point of inflection has arrived and the business is set to return to growth.

Most importantly, in our view, customer love the products.  We spoke with numerous customers of RST’s products on both the Education and Enterprise side, as well as former employees and competitors and feedback was overwhelmingly positive. Our strong impression is that the user base is highly loyal.

We believe that the E&E business is very conservatively worth 1.5x revenue. For reference, in late 2017, Pearson sold Wall Street English – a comparable business though a much less technologically intensive business model – at >1.5x revenue against negligible operating income. Additionally, we spoke with a competitor who indicated he’d readily pay 1.5x revenue for RST’s E&E business, but that a 2x-3x multiple struck him as much more reasonable.

Consumer Language (CL):

As recently as 2016 and 2017, CD sales represented 74% and 46% of sales for this business. For 2Q18, CD sales were just 3% of sales. The business model is now almost wholly oriented around app subscriptions.

Although revenues have continued to decline, that is largely due to the y/y impact of sharply declining CD sales. On an underlying basis, the CL business is – finally – on the upswing. Specifically, 2Q18 subscribers were +11.5% y/y and net LTV added (a function of new subscribers and LTV/unit) has been growing for the last few quarters.

While we don’t expect anything heroic from CL, we do believe it possesses significant optionality should the Company successfully market the subscription product.

Management:

RST is led by CEO John Hass who assumed the role in April 2015.

Prior to RST, John worked for Goldman Sachs from 1988 to 2006 where he was named a partner in the firm’s financial services investment banking group. Subsequent to leaving GS, John worked for a couple of investment firms and served as CEO of OptionHouse.

In our assessment, John has worked diligently to radically realign the Company’s business model and cost structure (LTM operating expenses are $107mm less than they were in 2014, though of course revenue and GP is also down a bunch). Specifically, he stewarded the business through a severe decline in the Company’s consumer language business and has now fully pivoted the business towards a subscription software model. Moreover, he has overseen tremendous growth from Lexia and has thoughtfully reinvested into the Company’s enterprise language business through the introduction of the Catalyst product.

John’s compensation highly incentivizes him to realize a materially higher stock price for RST. He currently owns (on a fully vested basis) more than 1.1mm shares of stock. John’s compensation is overwhelmingly in the form of stock-based compensation, with cash salary of only $200K in 2017.

Based on discussions with John and with people he’s worked for/with over the years, we believe he is a highly talented and trustworthy individual who will do the right things for the business and shareholders.

Other points:

We believe Rosetta Stone’s brand name is a meaningfully underappreciated asset. Hundreds of millions of dollars of TV and online advertising went into building the Rosetta Stone brand. While it is impossible to quantify the value of it, we believe it can create a lot of value. For example, RST could partner with a content production company and generate high quality educational videos for children. We would expect that parents would happily prefer to allow their children to watch cobranded Disney/Rosetta Stone youtube videos vs. the middling options that currently exist.

Valuation and Risk / Reward Profile:

The Company has outlined the following 2020 targets:

-         Literacy sales of $100mm

-         Language sales of $160mm

-         Adjusted EBITDA of $30mm

-         Ending cash balance of $100mm

-         Beyond 2020, the Company believes sales can grow mid-teens (led by 20% literacy growth) and generate mid-high teens EBITDA margins. Steady state – i.e. reduced growth – EBITDA margins are likely in the 30%+ range.

The Company provided further details on 2020 targets in their May 2017 investor day presentation. I expect the Company will provide additional color and perhaps some update to the numbers at their forthcoming November investor day.

The scenarios below present what we believe to be reasonable ranges of outcomes for RST. Specifically, we believe our extreme bear case incorporates substantial pessimism. And even in that scenario, we believe that downside risk is minimal insofar as a sale of the Company would likely yield a price above current levels.

Notes on scenarios:

-         2018 sales for Lexia are expected to be $60mm; our downside scenarios assume no further growth

-         2018 Language sales are expected to be $135mm split roughly evenly between E&E and CL; our downside scenarios assume just $90mm in Language sales

-         We ding RST for full corporate expense but we should note 2 items:

o   1) We believe a substantial majority of corporate expense is associated with standalone costs and would go away in the event RST is acquired

o   2) Lexia is run wholly independently and effectively zero corporate expense is attributable to it

We think the multiples we use in all cases – but especially the downside cases – are highly conservative

Catalyst

-          Underlying business performance & investor awareness

-          Reiteration of 2020 targets

-          Sale of Company

Risks

-          Execution & competition

Catalyst

Catalyst

-          Underlying business performance & investor awareness

-          Reiteration of 2020 targets

-          Sale of Company