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Rosetta Stone (RST)

Rosetta Stone (RST)

In the fourth quarter we invested in Rosetta Stone (RST). In Rosetta Stone, we see a historical fact pattern that has generated outsized returns for us in the past. In 2016, a new management team acted like business owners and made the difficult decision to fundamentally change the product portfolio and go to market strategy as they repositioned the business from one that sold CD based language learning products to one that sold educational software to primary, middle, and secondary school customers. This repositioning entailed divesting assets that did not contribute to competitive advantages and investing in future growth through the income statement by means of Research & Development spending to build new products, and SG&A spending to shift the go to market strategy from channel selling to a direct sales force. This margin pressuring investment spending occurred in conjunction with a revenue pressuring move from a perpetual license business model to a software as a service business model. The combined sales and margin pressure resulted in quantitative pressure on earnings and valuation, which obfuscate underlying qualitative improvements in the competitive advantages inherent in the business model. What we are left with in Rosetta Stone is a legacy Consumer Language business that is now a subscription software business with subscribers growing twenty one percent year over year, an Enterprise and Education Language business that has funded significant investment in a new product with a strong product market fit, yet with corresponding revenue that will not hit the income statement until 2020, and a K-12 Literacy (Lexia) educational software business nearing an inflection in profitability. As we have experienced in other situations, when a software company moves from a perpetual license revenue model to a subscription based revenue model and aggressively front loads investment in product development and customer acquisition costs while the recurring revenue (and bulk of the customer lifetime value) remains back end loaded, and then when accelerating revenue growth coincides with growing margins from a highly scalable business model, the resulting shareholder returns are significant. With every business we invest in, we look for multiple ways to win. In Rosetta Stone, we see three.

First, Rosetta Stone’s K-12 language learning segment (Lexia) is in the land grab stage in which the goal is to drive penetration of the Core5 literacy product. From a current footprint in fourteen percent of US public schools, the actual district footprint represents forty percent of US public schools. By simply expanding to the schools within the districts where Lexia already has an existing presence, Lexia can triple its school footprint. In district penetration growth is supported by the strong product-market fit of Core5. Sixty four percent of fourth grade students do not read at their grade level. The cumulative effect of falling behind in literacy makes these students four times more likely to be among the seven thousand students who drop out of high school every single day. Despite a widely recognized need for improving elementary literacy, teachers do not have the resources they need to meet the needs of every student in the classroom. Lexia solves the complex challenge of reducing the time-consuming nature of collecting and interpreting student strengths and weaknesses, which then helps teachers identify student need, and prioritize their time and efforts. As individual teacher use cases grow, in district penetration growth and new district expansion is fueled both by Lexia’s ability to collect efficacious data to demonstrate student progress against a district’s measure of choice, and by a peer effect of principals and teachers talking to other principals and teachers. An established footprint then becomes the distribution channel through which Rosetta Stone can push new products onto the Lexia platform.

Second, Rosetta Stone’s K-12 Literacy business is an emerging platform with a long runway for organic growth. Historically, Lexia’s business consisted of selling a single vertical product, Core5, to elementary schools. Lexia then expanded to PowerUP, a literacy product in the early innings of penetrating the middle and high school market opportunity. The next product extension on the Lexia platform is the English Language Learning program. English Language Learning is the result of the largest investment in Rosetta Stone history, satisfies a significant need, and the associated revenue will not hit the income statement until the product launches in the 2020 school season. Lexia’s English Language Learning product addresses the ten percent of public-school students that are nonnative English speakers, a population that is set to double in the next five years. In addition to providing Lexia with the first upselling opportunity at the school level, the English Language Learning product makes Lexia more engrained in school curriculums, which raises switching costs while opening Lexia up to more federal, state, and local funding.

Third, secular tailwinds support growing educational technology end markets. Software is taking over most all industries, but it has not happened yet in educational technology. Changing US policy as shown in the 2020 National Educational Technology Plan acts as a catalyst to push educational technology along the growth curve to foster greater adoption in the classroom. As federal policy encourages grant funding for the use of technology to improve and personalize learning resources for students, Lexia stands to benefit from the scalability of their business model and generate outsized return from increased demand. Changing federal policy supports long term growth, but also near-term opportunity as Lexia moves seventy percent of the existing Core5 school customers from seat licenses to whole school licenses. Each successful contract change increases ARPU by three hundred percent, and full conversion more than doubles annual recurring revenue. As educational technology software use grows, Rosetta Stone’s scalable business model presents a significant opportunity to compound earnings growth over the long term.

As investors in Rosetta Stone, we get these three paths to value creation while owning a business with inflecting unit economics, a long runway to leverage high margin products across growing demand, and the competitive advantages that a closed customer feedback loop and established distribution channel provide in cross selling and up selling opportunities.

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