RST - Rosetta Stone

[KJP]

I've mentioned Rosetta Stone from time to time on various threads.  It's unlevered and has significant cash on the balance sheet.  The company's most important and valuable business is Lexia, which is an online literacy teaching tool, and they're rolling out a new "english as a second language" product.  The customers are largely public schools in the US, who sign up for annual contracts.  The business has been growing for years, though management has a bad habit of overpromising and should just stop issuing guidance altogether.  If you want to see what businesses like Lexia are worth in the private market (or were worth pre-corona), look at the Cambium Learning thread.

 

Not surprisingly, online learning tools like Lexia are in great demand right now, and management is doing a very smart thing to take advantage of that, which they detailed in an investor letter they released last night:  https://investors.rosettastone.com/static-files/04718fc3-8017-4cc6-91df-91f1f720b19c

 

I don't believe in the consumer language business, which is what most people associate with Rosetta Stone.  I read the last few paragraphs of the letter as a suggestion that the adult language business could be sold without interfering with Lexia's growth.

 

There are some things I don't like about the company, but it's one that has a balance sheet that can survive the crisis, customers who will still be around next year, and a product that's highly scalable and in demand. 

 

 

[KJP]

I'm not a fan of the consumer language business, but this is another smart effort to try to get their foot in the door with new potential users:  https://pr.rosettastone.com/news-releases/news-release-details/rosetta-stone-announces-free-language-subscriptions-students

[samwise]

Do you know if their customers keep paying through this environment? They were just cash flow neutral before this mess.

 

[KJP]

Do you know if their customers keep paying through this environment? They were just cash flow neutral before this mess.

 

Their customers mostly pay in advance for subscriptions, thus the large deferred revenue liability.  See pages F-11 and F-23 of the 2019 10-K for more details. 

 

Rosetta Stone's most important business is Lexia, which sells mainly to U.S. public (i.e., state- and local-government funded) schools.  Local taxing authorities are going to get squeezed by upcoming tax shortfalls.  The Democrats are already floating federal subsidies to state and local governments to deal with this, but there is some retention risk as the contracts expire.  That is why it's smart for them to get their foot in the door now with as many students as possible.  Once a school district starts its students on the Lexia platform it has little reason to switch. 

 

[samwise]

Thanks for the references! I guessed as much from the nature of their business and bought a bit last week.

 

Yes I believe online tailored education tools are the future and can see it in my kids school. The recent VIC writeup was convincing, though I have no way to corroborate some of the data used. Their online reviews are good too. So a good product in a growing market, where there are huge scale advantages (by consolidating sales force). They are not at scale though, so they don’t have free cash flow now. The eventual outcome is to scale up slowly, or sell to a strategic acquirer. But they need to survive this lockdown.

 

I guess their face to face sales efforts for the next school year are closed but they could still be talking over phones and FaceTime.  The market growth might be faster now after schools have experienced this shutdown. We shall see. If the sales force is inactive then they could be laid off.  That reduces future growth, but could be an option in a crunch.

[KJP]

Thanks for the references! I guessed as much from the nature of their business and bought a bit last week.

 

Yes I believe online tailored education tools are the future and can see it in my kids school. The recent VIC writeup was convincing, though I have no way to corroborate some of the data used. Their online reviews are good too. So a good product in a growing market, where there are huge scale advantages (by consolidating sales force). They are not at scale though, so they don’t have free cash flow now. The eventual outcome is to scale up slowly, or sell to a strategic acquirer. But they need to survive this lockdown.

 

I guess their face to face sales efforts for the next school year are closed but they could still be talking over phones and FaceTime.  The market growth might be faster now after schools have experienced this shutdown. We shall see. If the sales force is inactive then they could be laid off.  That reduces future growth, but could be an option in a crunch.

 

One thing I don't fully understand is the company's current cash flow, or, more accurately, lack of it.  If you look at Cambium when it was the same size as Lexia and growing quite fast, it was generating a lot of cash.  Rosetta Stone doesn't.  The reasons aren't clear to me, though Cambium had a lot of debt and a PE owner with a majority stake while RST has cash, so it wouldn't surprise me if Cambium was running a much tighter ship.

[samwise]

Haven’t looked at Cambium.

 

But in terms of school closures, Lexia seems prepared.

https://www.lexialearning.com/blog/are-you-prepared-extended-school-closure-lexia-supports-remote-learning-help-keep-students

 

Toronto school board uses razz kids. They don’t have it during this shutdown. Let’s see if they do after March break.

 

Edit: just checked. Cambium is using the school closures as an opportunity to market. They are offering free one year subscriptions to schools. https://www.learninga-z.com/site/lp2/covid19

 

Meanwhile RST is offering free language subscriptions to parents. Not sure why, when offering lexia to schools would be way better business. Schools that like it will renew every year, but not parents. https://apnews.com/Globe%20Newswire/ea80fc1b5c779a3ef6ba1e2b04eadeca

 

Both seem to be helping schools teach while closed.

https://www.albanyschools.org/healthservices/covid-19/news/1676646/schools-closed-through-march-27

 

https://www.postandcourier.com/health/covid19/how-charleston-area-schools-will-continue-instruction-during-coronavirus-closures/article_a58d9a48-6700-11ea-aeeb-170abbae01e8.html

[KJP]

Haven’t looked at Cambium.

 

But in terms of school closures, Lexia seems prepared.

https://www.lexialearning.com/blog/are-you-prepared-extended-school-closure-lexia-supports-remote-learning-help-keep-students

 

Toronto school board uses razz kids. They don’t have it during this shutdown. Let’s see if they do after March break.

 

Edit: just checked. Cambium is using the school closures as an opportunity to market. They are offering free one year subscriptions to schools. https://www.learninga-z.com/site/lp2/covid19

 

Meanwhile RST is offering free language subscriptions to parents. Not sure why, when offering lexia to schools would be way better business. Schools that like it will renew every year, but not parents. https://apnews.com/Globe%20Newswire/ea80fc1b5c779a3ef6ba1e2b04eadeca

 

Both seem to be helping schools teach while closed.

https://www.albanyschools.org/healthservices/covid-19/news/1676646/schools-closed-through-march-27

 

https://www.postandcourier.com/health/covid19/how-charleston-area-schools-will-continue-instruction-during-coronavirus-closures/article_a58d9a48-6700-11ea-aeeb-170abbae01e8.html

 

RST is offering expanded licenses to current customers: https://investors.rosettastone.com/static-files/04718fc3-8017-4cc6-91df-91f1f720b19c

 

I agree it would be smart to do even more on this front.

 

 

[DW1234]

E&E segment will probably decrease quite a bit because of COVID. This one has been declining for years now too. Doesn't look promising, and I wouldn't be surprised if this segment could drag down results a couple years from now.

 

Customer language has consistent margins but also lost a lot of business last couple years. Again, this doesn't look really promising. They might be able to get some extra subs because of COVID though. But long-term this segment doesn't look good.

 

Literacy does look really good. Very consistent growth, increasing margins, and very likely a bunch of added revenue due to COVID. This revenue is also way more recurring than the CL business. However if you extrapolate a 20% growth rate till 2022 with 25% gross margin, you get ~$27M 'Segment contribution'. It's unclear how much overhead is needed to get to this point (any idea?), but let's say it's about $15M overhead just for the literacy segment, you end up with EBIT ~$12M. Taxes are negligible with their NOLs. Let's use a 20x multiplier for this one and you end up with a valuation of $240M for Lexia. Add in ~$50M of cash = $290M.

 

Due to COVID these estimates could be a bit too conservative, but it's hard to tell. Couple Q's:

 

* Do you roughly agree with this valuation for Lexia?

* The other 2 segments could be a drag on results. How do you look at this?

 

[KJP]

E&E segment will probably decrease quite a bit because of COVID. This one has been declining for years now too. Doesn't look promising, and I wouldn't be surprised if this segment could drag down results a couple years from now.

 

Customer language has consistent margins but also lost a lot of business last couple years. Again, this doesn't look really promising. They might be able to get some extra subs because of COVID though. But long-term this segment doesn't look good.

 

Literacy does look really good. Very consistent growth, increasing margins, and very likely a bunch of added revenue due to COVID. This revenue is also way more recurring than the CL business. However if you extrapolate a 20% growth rate till 2022 with 25% gross margin, you get ~$27M 'Segment contribution'. It's unclear how much overhead is needed to get to this point (any idea?), but let's say it's about $15M overhead just for the literacy segment, you end up with EBIT ~$12M. Taxes are negligible with their NOLs. Let's use a 20x multiplier for this one and you end up with a valuation of $240M for Lexia. Add in ~$50M of cash = $290M.

 

Due to COVID these estimates could be a bit too conservative, but it's hard to tell. Couple Q's:

 

* Do you roughly agree with this valuation for Lexia?

* The other 2 segments could be a drag on results. How do you look at this?

 

I agree that E&E and Consumer Language aren't great businesses.  If Lexia didn't exist, I'd have no interest in this company.  I would prefer they sell E&E and Consumer (assuming they could get something decent for it) to fund additional growth at Lexia and/or capital distribution to shareholders.

 

In light of what Cambium was able to do at similar size and growth rates, Lexia's ongoing margins are a bit of a mystery to me.  I don't think they run a very tight ship.  Plus, I believe they've been investing heavily in the new ESL product and expanding/reorganizing the sales and support forces, which are drags on near term margins.  For all of those reasons, so long as they're not burning large amounts of cash, I'm looking at Lexia billings growth as the best indicator of how the business is doing, because I believe a billings multiple is the best indicator of private market value. 

 

If you told me there was no chance the business would be sold, I'd also be less interested.

 

EDIT:  I'd also look at bookings/billings (essentially revenue + change in deferred revenue) rather than revenue, because the former tracks cash flow.  If you assume 20% billings growth, you'd end up with 2022 Lexia billings of $117 million (68 *1.2^3).  Based on Cambium's financials, I believe the Lexia business ultimately should generate cash income margins of at least 25%-30% on billings (either under this management or someone else), after accounting for shared overhead.  So, that would be $30 - $35 million in cash flow that is, by hypothesis, still growing at 20%.  That, I think, is the bull case for Lexia. 

[DW1234]

2019 Lexia revenue is $62.6M. I'm not sure how you get to $68M in billings (I am curious though, wouldn't mind a PM about this if it clogs up the thread), but let's work with $68M. There are a couple of things which I don't like here:

 

* Historically margins have been quite a bit lower than 25%-30%. It seems management might not be as good as with Cambium (although I have v little knowledge about Cambium).  So management getting smarter or replaced is something which might need to happen.

* Let's say management/business gets better and margins will be 30%. This would be $35M EBITDA. However their EBITDA numbers exclude a lot of costs. Total overhead currently is about $60M. Let's be optimistic and assume Lexia uses 40% of overhead while having about 60%+ revenue at that point probably. That's $24M of overhead for Lexia alone, and EBIT of $11M. This is assuming overhead doesn't grow with revenues.

* This brings me to my next point. All of this assumes the drag from E&E and Customer language doesn't get worse.

* All of these assumptions also aren't very conservative. Lexia margins from 2019,2018,2017 were 16.12%, 13.59%, 11.38%. So getting from this to 30% isn't exactly a given. This space is probably very competitive too.

* COVID might help a lot with this, I have trouble estimating the impact of this.

 

 

[KJP]

2019 Lexia revenue is $62.6M. I'm not sure how you get to $68M in billings (I am curious though, wouldn't mind a PM about this if it clogs up the thread), but let's work with $68M. There are a couple of things which I don't like here:

 

I should have used the word "bookings" rather than "billings."  Revenue is a GAAP accrual-based number.  Bookings are cash-based and equal Revenue plus change in Deferred Revenue.  So, while the business is growing, revenue understates cash flow.  See slides 22-23 here:  https://investors.rosettastone.com/static-files/20e9bb41-83e2-4929-a612-602086c30016 

 

 

* Historically margins have been quite a bit lower than 25%-30%. It seems management might not be as good as with Cambium (although I have v little knowledge about Cambium).  So management getting smarter or replaced is something which might need to happen.

* Let's say management/business gets better and margins will be 30%. This would be $35M EBITDA. However their EBITDA numbers exclude a lot of costs. Total overhead currently is about $60M. Let's be optimistic and assume Lexia uses 40% of overhead while having about 60%+ revenue at that point probably. That's $24M of overhead for Lexia alone, and EBIT of $11M. This is assuming overhead doesn't grow with revenues.

* This brings me to my next point. All of this assumes the drag from E&E and Customer language doesn't get worse.

* All of these assumptions also aren't very conservative. Lexia margins from 2019,2018,2017 were 16.12%, 13.59%, 11.38%. So getting from this to 30% isn't exactly a given. This space is probably very competitive too.

* COVID might help a lot with this, I have trouble estimating the impact of this.

 

Cambium's LAZ segment was running at 30% post my back-of-the-envelope allocation of shared overhead/corporate, which Cambium reported in a way similar to Rosetta Stone.  I agree with you that it requires a big bridge to get from Rosetta Stone's historical financials to the bull case I outlined.   

 

The CEO has significant exposure to the equity (primarily via equities) and there are some Board members and/or larger holders that are likely looking over his shoulder a bit (Nierenberg, Osmium Partners).  That is part of the reason I believe the value of Lexia will ultimately be realized.

[KJP]

RST is spiking today on relatively high volume (~ +12%).  I have found no relevant new information from the company nor any relevant M&A news among EdTech comparables.  I'm obviously missing something.  Anybody have any insight?

[CLM5]

UPDATE: Rosetta Stone (RST) Said to Tap Adviser for Strategic Review - Bloomberg

(Updated - July 17, 2020 12:29 PM EDT) 

Rosetta Stone (NYSE: RST) is exploring strategic alternatives including a potential sale of all or part of the company, according to Bloomberg, citing people familiar with the matter. It's working with financial advisers to gauge interest from potential private equity and strategic buyers.

Fri, 17 Jul 2020 12:29:06 -0400

Copyright © 2020 StreetInsider.com

[KJP]

UPDATE: Rosetta Stone (RST) Said to Tap Adviser for Strategic Review - Bloomberg

(Updated - July 17, 2020 12:29 PM EDT) 

Rosetta Stone (NYSE: RST) is exploring strategic alternatives including a potential sale of all or part of the company, according to Bloomberg, citing people familiar with the matter. It's working with financial advisers to gauge interest from potential private equity and strategic buyers.

Fri, 17 Jul 2020 12:29:06 -0400

Copyright © 2020 StreetInsider.com

 

Thanks.  Somebody knew about this before the release and was having fun trading on it.

[libor.plus1]

I did a lot of of work on RST about a year ago and never really got the appeal as an investment. It's an incredibly competitive market, particularly the language division, and the Company had cash balance guidance that there was no way they were going to hit. I also don't really understand the market reaction to a potential sale. The M&A activity in the learning space has had some pretty mediocre results. I don't see how this gets a half billion valuation.

[KJP]

The M&A activity in the learning space has had some pretty mediocre results.

 

What specific M&A activity are you referring to?

 

As I've mentioned previously on this thread, I agree with you about the language business.  Lexia is the key here.

[KJP]

The M&A activity in the learning space has had some pretty mediocre results.

 

What specific M&A activity are you referring to?

 

As I've mentioned previously on this thread, I agree with you about the language business.  Lexia is the key here.

 

I'm still very curious to know what recent M&A you think is particularly relevant, but given the continued run I've been selling. 

[samwise]

I sold out too.

 

THE recent VIC writeup had priced this between 19-26 in a sale, so doesn't seem to be much upside in a sale, but lots of downside if there isn't a sale.

 

I heard that the recent activist Voss had a letter claiming $35 price. But I haven't seen it.

[KJP]

Rosetta Stone is being bought by an old friend (Cambium Learning) for $30/share:  https://pr.rosettastone.com/news-releases/news-release-details/cambium-learning-group-adds-rosetta-stone-its-portfolio-digital

 

I can only give myself a half pat on the back for this one, because I sold out too soon (as usual).  I hope some of you made some money on this.