Rosetta Stone Buyers Are Hard to Understand

 | Jun 12, 2013 | 10:00 AM EDT
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The Stephanie Gross Trust, a trust related to Rosetta Stone (RST) board member Patrick Gross, purchased more than 32,000 shares of stock in the company on June 7 at an average price of $15.32 per share, according to a Form 4 filed with the Securities and Exchange Commission.

When insiders or their families to tie themselves more closely to a company in this way -- increasing company-specific risk, rather than diversifying their wealth -- this would generally be thought to be irrational unless the insider was more confident than usual in the company's prospects. In fact, studies show a small outperformance effect associated with insider purchases.

A recent public offering in Rosetta Stone (which comes almost entirely from selling shareholders rather than the company itself) was priced at $16 per share, and the stock price recently fell, so the trust seems to have decided that the market overreacted to this news. We'd note that Gross' wife was buying shares in August, at prices of about $11.50 per share.

Before the announcement of the public offering, the language-learning software company had been up nicely for the year, and it is still up 25% year to date. Although financial results have not been good in absolute terms (Rosetta Stone is unprofitable on a trailing basis), the company did significantly beat adjusted earnings expectations in the last three quarters. Still, revenue fell 8% last quarter compared with the first quarter of 2012, and operating losses increased as a result. In fact, cash flow from operations, which had been positive a year earlier,  was slightly negative. So we would say that the business is not in good condition. However, even though Rosetta Stone used $9 million in cash during the quarter, it reported $139 million in cash on its balance sheet.

That's a pretty significant cash hoard, considering that Rosetta Stone's market capitalization is only about $340 million. On average, more than 180,000 shares of the stock are traded per day; at a current price of about $15.90, that makes for nearly $3 million in daily dollar volume. Still, since operating income numbers are so poor, the company has very little EBITDA in the context of its enterprise value, so valuing the company in those terms does not fill us with confidence either.

Wall Street analysts are projecting that the business will be narrowly profitable this year and then deliver $0.26 in earnings per share for 2014, but even if those forecasts prove accurate, they still imply a forward price-to-earnings ratio of 61. That's in addition to the sell-side analysts who apparently expect a strong reversal in the trends in the business from what we observed in the first quarter.

Bulls have claimed that the company has strong upside potential from using its free tablet and smartphone apps as sources of marketing, though of course these devices have already achieved considerable penetration, and we've noted the fall in both revenue and operating income. Analysts who are optimistic on the stock also point out that enterprise value is lower than revenue, though we'd generally consider that appropriate for a low-margin company. Rosetta Stone also doesn't make sense as an acquisition target to us: Its services would offer little to no synergies as a strategic acquisition, and the low cash flow numbers make it a highly unlikely target for private equity.

Also, despite this insider purchase, major shareholders in Rosetta Stone are dumping shares through the public offering. Potentially, their neutrality or pessimism on the stock should offset an investor's view of the optimism reflected by the trust's buying. The stock also doesn't seem to be a good buy on the basis of fundamental analysis at this time -- earnings are negative on a trailing basis, and even cash flow is very low -- and so we would avoid it.

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