Intriguing Ideas From The Las Vegas Value Investing Congress Part 1.

We attended the Value Investing Congress in Vegas last week, and instead of listing all the presentations and giving a brief summary, which can be found many places on the internet (herehere and here), we thought we would look at some of the ideas that warrant further analysis. Developing a strong process and sticking to it is much more important that the outcome of any particular investment idea. Over the long run, the correct process with produce the desired results. In this sense, investing is like playing Texas Hold’em. If you had a pair of Aces and raised pre-flop almost every time, you would made money in the long term (maybe not the “optimal” strategy for you hardcore players). But you would also have times where your hand would lose to a far inferior hand. That did not mean that your methodology was invalidated, just that other factors impacted the desired outcome.  Most of the ideas presented have some investment merit and were well thought out and presented. While Peter Lynch always said you should be able to present your investment case in three minutes or less, 25-35 minutes to present some of the ideas weren’t enough to cover all the factors involved in certain ideas — and that is as it should be. There was something for every kind of value investor. Finding ideas with markets and most stocks at or near all-time highs means it is not the easiest time to find lots of profitable value ideas.

Whitney Tilson suggested that the three most dangerous words in investing are “I missed it,” and that discounting stocks that have had big runs can cause investors to miss substantial appreciation (AIG (AIG) and Netflix (NFLX) were a couple of examples). However, we want to focus on some ideas that are a bit nontraditional. Our usual caveat is that everyone needs to do their own work on an investment idea and not just blindly buy or sell or short a stock because a famous investor or other credible source says to do it. Each investor has a different risk tolerance and investment horizon, which may or may not match up to the presenter’s.

Rosetta Stone (RST) — Presenter: David Nierenberg of D3 Funds

Our first idea is a stock that was a great short for the last two years and went down 10% on the earnings announcement that occurred just after the Congress. Nierenberg (a Guru Focus guru) led off the Congress with RST. The firm likes “busted” growth names that are potentially posed to resume that once promised growth due to new management and a renewed focus on the basic fundamentals of the business.

Reasons Given for the Stock Price Collapse

1. The company had bloated international sales and marketing costs as it tried to maintain a high sales growth rate. This is very typical of a high growth story stock and a short seller’s favorite type of short. It’s a growth stock that can’t meet the market’s expectations and valuation. As both collapse, the stock declines substantially.

2. Kiosk strategy was a low ROI sale channel. A low-margin sales channel dilutes margins for the sake of growth. It’s more like advertising cost than profitable sales.

3. Online and mobile products were weak. There was no iPad app until recently, and it’s now in the “cloud.”

4. Competitive threat from massive open online courses (MOOCs) is increasing. High-profile MOOCs like Kahn Academy and San Jose St. create competition. Several New York Times articles (here and here and here) create plausible doubt about business model and sustainability of high gross margins and sales growth rates. We have no great insight as to how much of an impact MOOCs will have on RST — and there are plenty of rebuttals to their potential (here and here, for example) — but, admittedly, it is a major factor.

Investment Thesis

1. New management is cutting “empty calorie marketing spend” in international markets and eliminating kiosks in the U.S. (from 250+ in 2010 to zero by 2014). Former mismanagement has created an opportunity. This is a classic example of growing the top line without paying attention to bottom line, something that is all too common with both Internet- and non-Internet-focused companies. Usually it takes new management to break the culture, and that usually comes after problems materialize and valuations contract.

2. It’s a large, growing, and fragmented market ($1.3 billion out of $82 billion global language market) with No. 1 player (Berlitz) controlling only 0.62% of the market. RST has 0.34% market share. True market size is difficult too estimate, but lots of room for “growth.”

3. Returning to unit growth and business model has high, 80%+ gross margins that can fund R&D and other growth initiatives.

4. The company is very inexpensive if 2015 financial objectives are achieved. In our opinion, you need to have a valuation that allows for wide margin for error in both margin and growth rate estimates. Valuation appears to allow for that even if 2015 targets are not achieved.

RST 2015 Targets
2011 Actual 2012 Actual 2015 Target
Revenue $269M $273M $400M
Gross Margin 82% 82% 82-85%
Sales and Marketing 60% 55% 45-50%
R&D 9% 9% 9-11%
G&A 23% 20% 15-18%
Adjusted EBITDA -2% 5% 10-13%
EBITDA Dollars -$6M $14M $40-52M

We always advise caution when using comparable valuation metrics but, as the table below shows, if the company can achieve its financial objectives, the stock is not only relatively inexpensive but absolutely inexpensive as well.

Comparable Valuation
EV/Sales EV/EBITDA EV/FCF
Education Services 1.7X 11.7X 22.3X
SaaS 3.0X 14.6X 21.2X
Internet Services 1.4X 9.9X 13.8X
Hi Tech Consumer 1.1X 8.1X 15.9X
Peer Average 1.8X 11.1X 18.3X
Peer Median 1.6X 10.8X 18.5X
RST valuation on 2015 Targets 0.4X 3.3x 4.5X

Risks Covered in Presentation

D3 has reasonable responses to these questions (you can find them by doing an Internet search), but you have to be comfortable with your own answers — not theirs or ours.

1. How are margins sustainable given the proliferation of free/low cost apps?

2. Many RST customers do not finish the course.

3. Consider consumer spending headwinds in general.

4. ABS plus Norwest 40% private equity stake sales could pressure shares.

5. There is execution risk with a first-time CEO.

Price Objective and Methodology

1. There’s a potential price range of $28-$60 depending on success.

2. $28 base case

  • 8.6X EV/EBITDA
  • 1.2X EV/Sales
  • 11.7X EV/FCF

3. $60 optimistic case

  • 3X EV/Sales
  • 10X EV/EBTIDA

4. Downside about $12

  • $164m cash + $100m Brand Value

Things We Liked

1. Strong balance sheet and cash flow. $150 million cash balance on $350 million market cap. Large cash balance gives company tremendous flexibility to turn business around at a measured pace. Free cash flow generation also a plus, because it can do acquisitions and still increase EV with increasing cash.

2. New CEO has had success with turnarounds before and making tangible progress in cost reductions ($20 million turnaround in EBITDA in first year). New management always something we like to see in “turnarounds,” especially ones with proven track records. D3 vetted CEO through their Bain connections.

3. Despite lack of success internationally, the demand for others to learn English seems to be much greater than the demand for Americans to learn other languages and is a large growth opportunity. A return to international areas in a more prudent, cost-efficient way would be a positive.

4. A 75% upside to its base case, which is based on reasonable assumptions on strategy and valuation metrics, seems acceptable for the risks.

5. Little analyst coverage, all of it by smaller regional firms. (On the last call, three of the five analysts had their assistants ask questions.)

6. Valuation metrics do not price in substantial growth or success of turnaround.

7. The fact the stock declined 10% on an earnings miss shows there are still lots of short-term focused investors in the stock, allowing for time arbitrage.

Concerns We Have

1. While language learning market is huge, the addressable market is much smaller. The fact that the No. 1 player has less than 0.75% of the total market shows how difficult it is to capture market share. Fragmented market is a sign of just how diverse the learning options are.

2. There seems to be an “impulse buy” component to their products (kiosks and commercials), which makes the “need” vs. “want” aspect of their products difficult to understand. While there are many successful companies selling the consumer “wants,” this is a tougher sell to us.

3. Also hard to gauge the “stickiness” of its products. Once you learn a language, how much follow up do you do? Do you then want to learn another language (product)? Institutional segment helps offset this somewhat.

4. The $100 million “brand value,” based on a conservative estimate of total R&D worth, may or may not be viewed similarly by other investors. The $12 “downside support” may be too aggressive (stock traded as low as $7 in 2011-12, but not a big negative).

5. MOOCs are the current threat and it is tough to handicap the competition. However, during the presentation it was brought up that San Jose St., one of the first adopters of MOOC, was experiencing resistance to the idea by some of the faculty. Even with positive merits to the idea of MOOCs, widespread adoption will take a tremendous amount of time and effort.

6. Most value investors would have sold out long before the valuation metrics used to justify the $60+ price targets would be achieved. While RST could trade at 2-4x EV/sales, we think very few investors buying the stock today would realize that type of gain. But it is possible.

Summary

We believe that looking at other successful investors’ ideas when trying to find new ideas can be a rewarding strategy. The investment case for RST is very interesting and seems reasonable to us. However, we also believe that simply reading a presentation or just hearing the basic idea and investing in it with no additional work can be a failed strategy. All investors make mistakes, even very successful ones, and everyone has their own investment style, risk tolerance, investment horizon and investing goals.

Investing conferences have become extremely popular and most of the investment ideas are widely disseminated within minutes of their presentation. However, knowing a ticker symbol, the story, and the well-respected presenter is not really doing analysis or using an investment process. Use their expertise and skill to help shorten the time it takes to do your analysis, but don’t let it take the place of it. Of course, you could always just let them manage your money for you.

Other ideas we might discuss as part of this series include Dole Food Company (DOLE), WPX Energy Inc. (WPX), Atlas Financial Holdings (AFH), Spark Networks, Inc. (LOV), Hertz Global Holdings, Inc. (HTZ), Nathan’s Famous, Inc. (NATH), The Western Union Company (WU) and FPA’s big-cap plays Microsoft (MSFT), Oracle (ORCL), and Occidental Petroleum Corporation (OXY). Live Nation Entertainment (LYV) was also presented at the conference. You can read our article, which was written the week before the conference, here. Two other companies that were presented — Blucora Inc. (BCOR) and Imperial Holdings, Inc. (IFT) — were discussed on Seeking Alpha here and here.

 

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Comments

  1. Interesting take. I think the analysis of the price collapse is mostly good but competition has been misjudged. Cash and Brand have been well identified as the two pillars still supporting RST so far. But they are both under or about to be under heavy pressure. Btw comparison with NFLX are nonsense, NFLX is a leader in it’s offering and pricing and has been highly disruptive not disrupted, they worries were not the same either.

    So I’m short RST and here is my reasoning: There is new competition in town and they have overwhelming advantages over Rosetta stone. They are babbel, memrise but above all Duolingo..

    I will also add that you can’t compare RST to berlitz, Berlitz is about teachers though they acquired telelangue sa which has a focus on e-learning (mostly through teachers again but they also have web based learning).

    No back to the real competition, babbel, memrise and Duolingo. I will focuss on Duolingo as they are the closest to RST. Duolingo offers better results (including a study they ordered showing that 34hours of Duolingo equal 55hours of Rosetta stone) for FREE.

    We could stop here but Duolingo business model and background let them focus on making you learn efficiently (well executed gamification and metrics-driven) while RST new “business model” ( switching from physical media to subscription web learning) give them every incentive to push customers to learn slowly enough to keep paying but without losing motivation and dropping the subscription. Big contradiction. And as you said stickiness outside of institutionals (10 to 20% of revenues) is doubtful.

    That leaves RST with only two advantages left: Brand awareness/marketing and more languages.
    1- I think Brand awareness is everything to Rosetta stone and that’s where their value is. However defending the brand with marketing is very costly, if they reduce spending, brand will fade. That’s going to put a lot of pressure on potential profits. RST has always been way more about the brand rather than the product qualities (they do a notoriously poor job in teaching grammar). If they choose to invest in the products instead, it’s going to cost a lot too. That’s why I expect RST to burn its cash in marketing and possibly real product innovation trying to stay relevant.

    2- More languages, RST offers more languages than the competition however it has come under customer criticism for re-using the same template in very different languages and while the spanish version may have ok reception the chinese one is badly rated. Moreover main competition (duolingo) is in the process of adopting a new collaborative model where they let users add new languages. I think a good comparison would be that Duolingo has everything to be to RST what Wikipedia has been to Microsoft Encarta. But it’s not there yet so in the meantime RST still has the clear advantage of having more languages than the competition.

    Now where my analysis could fall short: The other solution would be to kill cost hard and milk the non-informed customers while it lasts. That’s what a realistic ex-CFO could try to do if you give him the rein but I’m not sure how shareholders would react to a declining topline in a growth market that’s under disruption. And in the age of the internet, when your product is migrating from the cd-rom to the web, you find yourself in a more transparent environment where it should be harder to charge hundreds of dollars for a product that is inferior to the FREE competition. But while it lowers the brand value, it’s still a strategy as long as RST can manage a profit. And maybe it’s also possible to be allin on online marketing and cut everything else if ROI is high enough. Competition could also fail to execute and give more time to RST.

    In conclusion, I think RST is stuck between a rock and a hard place. Its current business model has no future. It’s all about managing the decline and it is at the mercy of the competition. Today, I would not encourage anyone to buy RST. Shorting it is about how you compute the current valuation and the strategy of the management. They might manage the decline well enough to maintain the current valuation for a while, they might be able to find someone to overpay for the brand (dubious). They might successfully change their business model to online sessions . But it would require a lot of new investment as the infrastructure needed and the teachers in third world countries are way more costly than milking a software that has already been been paid for. And it’s not where RST current field of expertise lies. So to me, either they slowly or quickly go out of business or they will have to burn a lot that nice cash pile to really change their business model this time.

    • Tim Heitman says:

      Those are all very reasonable points as to why the stock could suffer. Thank you for taking the time to write such a detailed post.