U.S. Markets closed

Edited Transcript of RST earnings conference call or presentation 2-Aug-18 9:00pm GMT

Q2 2018 Rosetta Stone Inc Earnings Call

Arlington Aug 15, 2018 (Thomson StreetEvents) -- Edited Transcript of Rosetta Stone Inc earnings conference call or presentation Thursday, August 2, 2018 at 9:00:00pm GMT

TEXT version of Transcript

================================================================================

Corporate Participants

================================================================================

* A. John Hass

Rosetta Stone Inc. - Chairman, President & CEO

* Jason Terry

================================================================================

Conference Call Participants

================================================================================

* Alexander Peter Paris

Barrington Research Associates, Inc., Research Division - Director of Research and Education & Business Services Analyst

* John Hartnett Lewis

Osmium Partners, LLC - Managing Partner, CIO, and Co-Founder

* Kevin Manthie

* Steven Bruce Frankel

Dougherty & Company LLC, Research Division - Senior VP & Director of Research

================================================================================

Presentation

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

Greetings, and welcome to the Rosetta Stone Inc. Second Quarter 2018 Results Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host today, Jason Terry, IR for Rosetta Stone Inc. Please proceed.

--------------------------------------------------------------------------------

Jason Terry, [2]

--------------------------------------------------------------------------------

Thank you. Good afternoon, everyone. Welcome to the Rosetta Stone Second Quarter 2018 Earnings Conference Call. Speaking on the call today will be Rosetta Stone's Chairman, President and CEO, John Hass. Additionally, Tom Pierno, the company's Chief Financial Officer, will be available during the Q&A portion of today's call. We have posted to the Investor Relations section of our website at rosettastone.com both the earnings release and a slide presentation that accompanies today's call. We have also posted supplemental information and analysis on our website. This supplemental information will not be read on today's call. I want to remind everyone that as always, there'll be elements of today's presentation which are forward-looking and are based on our best view of the world and our businesses as we see them today. We undertake no obligation to update such forward-looking statements. Cautionary comments regarding forward-looking statements are outlined on Slide 2 of today's presentation, which apply to our comments today. Today's presentation and discussion also contain references to non-GAAP financial measures. The full definition, GAAP comparisons and a reconciliation of those measures are available in the aforementioned presentation and press release. Our non-GAAP measures may not be comparable to those used by other companies, and we encourage you to review and understand all of our financial reporting before making any investment decision.

I will now turn the call over to John.

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [3]

--------------------------------------------------------------------------------

Thank you, Jason, and good afternoon. Over the last few quarters, these calls have focused on a high-level discussion of our products, businesses and goals for the future. Going forward, I would like to go deeper in some of the key areas that investors often ask us about. In doing so, we hope to build the library of knowledge to help you better understand our business. Today, as students prepare to go back to school, I will discuss why literacy is a focus for us, the company otherwise best known for the quality of its language software. But before I turn to the literacy discussion, let me share a few updates from the quarter.

Overall, turning to Slide 3, we are a different business than we were just a few years ago. We have a powerful and growing K-12 literacy franchise and a highly profitable, more predictable language business. Our sales are now 100% subscription-based and as this base of predictable SaaS sales grows, it will lead to improving cash flow as we leverage a significantly reduced cost structure. As we've said in the past, absent new opportunities to invest in the business, we'll return capital to shareholders. We expect to grow our cash balance to approximately $100 million by the end of 2020, with increasing cash flow from there.

Turning to Slide 4. I was very happy with the performance of our Literacy business in the second quarter. Literacy sales grew 20% over the same period in 2017 to $10.3 million, while ARR increased to $45 million. As a reminder, when we say sales, we are referring to a signed contract or transaction, the majority of which are paid upfront that is recognized as revenue over the duration of the license activation term. We achieved this growth despite the fact that similar to last year, we are seeing both renewals and new business sales shift from the second to the third quarter. In fact, the just completed month of July was larger in terms of sales than the entire second quarter and, at 40% higher than July of last year, was by far the largest single month in Lexia's history. We believe the shift of sales to Q3 represents both an industry trend and a change for Lexia, with our products moved to the center of schools' literacy curriculum. And consequently, follow school cycle for operating budgets. Lexia's importance to its school customers is demonstrated by their extraordinarily high-retention rate, 94% in Q2, the ninth consecutive quarter above 90%, the period which coincides with when we assume sales and implementation responsibility in most of the U.S.

With strong growth and retention, we remain on track to hit our $60 million Literacy sales goal this year. This would represent an increase of a little over 25% from 2017. Importantly, while we are building out sales support areas, we expect to achieve this growth with little additional direct sales headcount versus last year. If we achieve our direct sales expectations for the year, sales per average sales rep will grow from approximately $875,000 in 2017 to approximately $1 million in 2018. One of the ways we will continue to make progress is through our initiative to service and partner with some of the largest school districts in the country, an area that we began to focus on during the latter half of 2017. These opportunities carry longer lead times and as such we don't expect to see the benefit until next year. But we are happy to be included in these conversations and to be considered for these types of larger-scale implementations. Our positive momentum in this area is supported by the evolution of our Literacy product in services portfolio with the recent additions of RAPID and especially PowerUp. I'll share one example, which is highlighted on Slide 5. In collaboration with one of our third-party sales partners, last year, we were invited into a large California school district to pilot our RAPID Assessment product. While the RAPID pilot is ongoing, the introduction allowed us to bring Core5 and PowerUp into the conversation at the district level. This led to the district purchasing 39 new unlimited Core5 school licenses, and 7 new combine Core5 PowerUp licenses in more than sevenfold increase in the size of our relationship with the district. Each of our products, Core5, PowerUp, and RAPID, played a critical role in growing this relationship. This is not an isolated case. We are seeing the products in our Literacy portfolio, especially Core5 and PowerUp, reinforce each other as we offer customers compelling solutions that are easy to implement regardless of need. Continually improving our product portfolio therefore remains a focus.

Slide 6 lists critical new releases across our entire Literacy portfolio that were introduced in time for the new school year. I'll highlight 2. Core5 Version 3 takes us out of flash-end browser, but unlike many competitors, as we move from flash to HTML5, we upgraded the code base to include our own animation engine based on industry standards that allows us to move the engagement of our award-winning Literacy learning program to new levels. We also released PowerUp Version 1.1. PowerUp is Lexia's literacy learning product for older, struggling learners in grades 6 through 12 that was launched in January. This is an important content release for PowerUp, which incorporates many new features that were directly driven by feedback from our customers. Nick Gaehde and our Literacy team can't wait to share Core5 and PowerUp with you during our Investor Day, which I will talk about more at the end of my comments.

In Language, highlighted on Slide 7, I was pleased with the performance of our Enterprise & Education team, while sales were down overall primarily due to lower sales of custom content and sales through our affiliate channel. ARR was up on a sequential basis from second consecutive quarter and totaled $55.8 million. We continue to see progress on our corporate business and expect this to become increasingly apparent as we focus on larger, critical need-use cases for our customers. As an example, in July, we were awarded a global contract from a Fortune Global 500 consulting firm that we expect to be at least $1 million annually, the largest annual corporate deal in our history. It includes over 10,000 language licenses and capitalizes on our ability to provide virtual online tutoring to their learners around the world. This was a competitive process for a marquee client and is a perfect example of an opportunity that would've been very difficult to compete for prior to the introduction of Catalyst. In fact, we lost in our [feat] for this client 5 years ago before we were able to offer the comprehensive product and tutoring solution through Catalyst that we have today. Armed with these improved capabilities, Fortune 500 and larger accounts generally will remain a concerted focus for our E&E team. In Consumer Language, we are seeing progress in important areas of our direct-to-consumer or DTC channel and in particular, mobile apps with growth in new unit sales and total subscribers at attractive LTVs. The strong performance in DTC was offset by weakness in our retail channel, which did not meet our expectations as we shifted from selling physical products to subscription licenses. While retail is down substantially year-over-year, it is expected to be only about 10% of our Consumer Language business. We are beginning to see some signs of improved performance as we worked with our partners to better position in market on new subscription products through their channels. Consumer sales are also being temporarily affected by the year-over-year shift to shorter-term subscriptions that have lower upfront per unit sales prices. This lowers immediate sales relative to longer-term subscriptions or our perpetual of sales that is largely made up over time through higher renewal rates. Any perpetual to subscription transition is not without its bumps in transitional effects. But to-date, I feel good about our execution.

As shown on Slide 8, growing DTC unit sales drove total subscribers from 395,000 at the end of Q1 to 417,000 at the end of Q2, with the growth coming from short-term subscriptions. You can see on the right-hand side of the slide the short-term subscriptions, those with an initial subscription term of 1 year or less, are now almost 60% of our total outstanding units, up from less than 10% in 2016.

In aggregate, on Slide 9, consumer net LTV added in Q2 was $6.2 million, an increase of 3% versus the same period in 2017.

Remember that our goal in Consumer is to maximize and grow the aggregate dollar amount of net long-term value created each quarter. We could operate Consumer at higher LTV to CAC ratios, but would sacrifice aggregate profitability in doing so. I'm very happy that our consumer business, after accounting for essentially all fixed and variable sales and marketing costs, that's both people and marketing dollars, produced over $6 million in net value through initial sales and expected future renewals during the seasonally slowest quarter of the year. Consumer is creating substantial value for us and has the opportunity to create even more in the future. We are doing this today by optimizing the balance of subscription growth while maintaining attractive sales per subscriber. Over time, we will look for ways to accelerate growth and add to LTV per customer. Matt Hulett and team are intensely focused on this opportunity, and the pace of testing and innovation occurring in Consumer is higher than it has ever been.

On Slide 10, let me conclude this portion of the call by confirming our revenue, adjusted EBITDA and net income guidance for the year. I would remind everyone that the recent GAAP performance deteriorates this year, even if we expect sales to grow, is due to the temporary effects of the conversion of our consumer business to a full subscription model. We are confirming our sales guidance for Literacy in any language. We are lowering our sales outlook in Consumer Language to $66 million due to the performance of retail and the higher-than-expected mix in short-term subscriptions.

We now expect consolidated sales to be approximately $192 million, which represents sales growth of $10 million after 3 years of decline. We expect to end the year with $45 million in cash, an increase of $24 million from the end of Q2. This is a little lower than previously estimated. I would now like to spend the rest of my time discussing how Literacy has grown to be one of the two pillars of our business.

On Slide 11, it begins with our mission as a company to change people's lives through the power of language and literacy education. Helping people to speak and to read is the core of who we are. With this mission, we are focusing our efforts on 2 of the most important societal needs in learning today: childhood literacy in United States; and the desire to learn English globally. For this call, I will focus on what is driving the literacy need in the United States and why we are well positioned to address it. In the future, we will focus on the opportunity in English language learning.

On Slide 12, childhood literacy in United States is often said to be in a crisis. Unfortunately, this label doesn't fit the facts as the crisis suggests a moment in time. The United States, however, has persistently failed to build sufficient literacy skills in its children. In fact, for decades, 2/3 of eight grade students, as shown on this slide with the yellow line, have been classified as nonproficient readers. This is from what is known as the nation's report card, the National Assessment of Educational Progress, which is completed every 2 years. We see a similar trend over the years in the fourth grade results. This is the fundamental problem in K-12 education in the United States and a critical issue for all of us. Nonproficient readers are not just more likely to struggle in school, but also more likely to drop out or fail to graduate on time, creating persistent challenges throughout their life, impacting our society as a whole. As a country, we recognize this problem. So why has it endured for so long? Imagine if you will a well-funded traditional second grade classroom.

Turning to Slide 13. There may be 22 children in the room with the teacher. In that classroom, they might spend 90 minutes a day in their literacy block, these are materials from traditional providers. That means if the teacher wants to spend time with each student individually, they would have just about 4 minutes per student. Not much time. Oftentimes, the teachers don't have the critical tools and data needed to understand what the needs of each child are. And even if they did, they couldn't provide individualized instruction to address them. Consequently, they are left teaching to the mean, and we know from research and experience that each child is different. Children learn in different ways, and each student's learning pace may be different than his or her peers. They struggle with different areas of literacy acquisition and receive varying levels of support inside and outside the classroom. Consequently, the conventional approach doesn't work very well even in the best circumstances.

Now assume the school has greater burdens. There are 30 kids in the classroom, reducing the teacher's time to 3 minutes per student. Assume many of the children come from homes where providing educational support outside of school is more difficult due to time or economic constraints. In many instances, they are emerging bilinguals, learning English while trying to progress in school. In the thousands of schools where these facts are the norm, not the exception, educators will struggle to be successful. They are limited to traditional approaches. So when we consider all of these factors, it is actually quite easy to see how teaching a child to read can be quite difficult. But there is hope. Instructional software that empowers students and educators and provides alternative individualized paths to instruction transforms the traditional one-size-fits-all approach.

Turn to Slide 14. Let's put Lexia at the center of that same 90-minute literacy block. Lexia can be used to provide personalized, data-driven instruction and activities that transform how students learn and educators teach. A group of children can start the reading block, working for 30 minutes in our comprehensive reading instruction program, Core5, at an appropriate level matched to their needs and in a learning path that adapts to their progress, providing structured support when and where appropriate. And it is important to note that they're English language learners learning to read English. The directions and instructions in Core5 can be provided in 6 additional languages to match the native language of the child. Next, that group of children moves toward directly with the teacher for 30 minutes where they use teacher-led lessons provided by Core5 based on each student's needs. The teacher is empowered to help the children by using the data captured in Core5 and shared with them through their data dashboard, myLexia. The myLexia portal helps teacher group students with similar needs and provides links to lesson plans, targeting specific skills that, that group of students are struggling with in their online activities. For the last 30 minutes, those children can practice what they're learning by reading a book or other material.

By the way, we are not in this part of the reading block today. With this approach, children are empowered because they are working an engaging software that guides them along a journey developed from decades of research to support their progress. The teacher is able to optimize his or her most valuable resource, time, to provide targeted guidance using tools and information to clearly show them what is needed and how to provide it. This is an important and fundamental change in the approach to learning. And we have to do better. It's -- not only has U.S. literacy education been a persistent problem, it is a large one.

Turning to Slide 15. There are approximately 100,000 public schools in the United States and another 30,000 private and parochial schools. The good news is, we are already making an impact. Lexia is now in about 12,000 U.S. schools. But why Lexia? A few things clearly set us apart.

Turning to Slide 16. First, Lexia's history and focus. Lexia has been solely focused on using technology to address literacy needs since its founding 34 years ago. Even then, Lexia has found or recognized the power of technology to drive individual assessment, personalized learning and optimize teaching strategies at scale. Second, Lexia is also unique in the depth and quality of its research and how this informs its approach to instruction. Lexia was started, in part, through a grant from the National Institute of Child Health and Human Development, and has maintained this focus on research throughout its history. This research is unrivaled in depth and quality, with more peer-reviewed published studies than anyone else in this space. The covers of a few of these studies are represented here. The results of 1 study are shown on the left of the slide. In this study, published and computers in schools, English-language learning students using Core5 almost entirely closed the reading gap of a controlled group of native English-speaking learners. The proven ability to repeatedly drive outcomes like this is what makes our offering so compelling. And while Lexia's focus on research has existed for decades, its Literacy portfolio, shown on Slide 17, as we have discussed on prior calls, is new and more comprehensive than other alternatives in the marketplace. From Core5 and PowerUp in curriculum, to RAPID in assessment, to the data analytics available through myLexia, we have the tools to improve outcomes for all students. And we also have high-quality implementation services to drive successful implementations and achieve school and district-specific goals. So even though we are smaller than the biggest general education players in the K-12 space, Lexia delivers unmatched experience, expertise and capability in literacy education. Our ambitions for our Literacy business are substantial. The societal needs that we are addressing is huge. Ultimately, we will not be satisfied until new roles are open through literacy for every child in the United States regardless of circumstance.

Finally, I want to let you know, on Slide 18, that we will be holding our annual Investor Day on November 6 in New York City. This year, we will focus on the products we are using to change lives in our language and literacy businesses, and the way we see our business evolving in the U.S. and internationally. We will walk you through the innovation we are bringing to the marketplace and previewing some of the exciting products and investment opportunities coming next as we leverage our growing leadership in K-12 literacy and our iconic Rosetta Stone language brand. Among other things, we will preview the work we have begun to bring the brand-new product to build the language proficiency for English Language Learners to the K-12 marketplace, a product which will be the fulfillment of one of the opportunities that originally provide Rosetta Stone and Lexia together. I hope all of you can join us.

With that, operator, could you please open the line for questions?

================================================================================

Questions and Answers

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

(Operator Instructions) Our first question comes from Alex Paris with Barrington Research.

--------------------------------------------------------------------------------

Alexander Peter Paris, Barrington Research Associates, Inc., Research Division - Director of Research and Education & Business Services Analyst [2]

--------------------------------------------------------------------------------

I have a couple of questions. I guess, we'll start first with guidance. I don't know if I got that exactly, John. What -- the only real difference versus your previous guidance was a reduction in sales expectations for Consumer Language. Is that correct?

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [3]

--------------------------------------------------------------------------------

That's correct, yes. We -- because of the shortfall in retail year-to-date, we had to reduce that a bit. Everything else we are holding tight with and feel good about.

--------------------------------------------------------------------------------

Alexander Peter Paris, Barrington Research Associates, Inc., Research Division - Director of Research and Education & Business Services Analyst [4]

--------------------------------------------------------------------------------

So you reduced Consumer Language from what to what?

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [5]

--------------------------------------------------------------------------------

We reduced Consumer Language from $66 million to $62 million.

--------------------------------------------------------------------------------

Alexander Peter Paris, Barrington Research Associates, Inc., Research Division - Director of Research and Education & Business Services Analyst [6]

--------------------------------------------------------------------------------

Okay. So that's probably about [$3 million]. That’s the $4 million reduction on full year sales. Okay. And then...

--------------------------------------------------------------------------------

Unidentified Company Representative, [7]

--------------------------------------------------------------------------------

To $66 million.

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [8]

--------------------------------------------------------------------------------

I'm sorry. Alex, yes, it was from $70 million to $66 million.

--------------------------------------------------------------------------------

Unidentified Company Representative, [9]

--------------------------------------------------------------------------------

Sorry about that.

--------------------------------------------------------------------------------

Alexander Peter Paris, Barrington Research Associates, Inc., Research Division - Director of Research and Education & Business Services Analyst [10]

--------------------------------------------------------------------------------

$70 million to $66 million. Got you.

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [11]

--------------------------------------------------------------------------------

Yes. Spoke to soon.

--------------------------------------------------------------------------------

Alexander Peter Paris, Barrington Research Associates, Inc., Research Division - Director of Research and Education & Business Services Analyst [12]

--------------------------------------------------------------------------------

Okay. Yes. And then no change to the adjusted EBITDA, no change to expected capital expenditures. And then you said cash will be around $45 million as opposed to your original projection of $48 million.

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [13]

--------------------------------------------------------------------------------

Yes. And again, that's tied to the consumer retail sales.

--------------------------------------------------------------------------------

Alexander Peter Paris, Barrington Research Associates, Inc., Research Division - Director of Research and Education & Business Services Analyst [14]

--------------------------------------------------------------------------------

Got you. Okay. So thank you for the deep dive into Lexia. I appreciate it. I just had one follow-up question there. So with Core5, RAPID and PowerUp, question is, I see the power of the package, as you noted in California and so on. But can you buy these products? Or do your customers buy these products separately? Is PowerUp selling independently of Core5? Or are they usually sold more as a package?

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [15]

--------------------------------------------------------------------------------

Yes -- no. It's a really good question. You can absolutely buy them independently. But one of the things we've done, which I believe has been very good for the marketplace and very good to get PowerUp to -- PowerUp off to a great start, is to give customers license flexibility. Now let me give you a bit of an example as to what that means. So Core5 is pre-K through fifth grade, PowerUp is sixth grade through 12th grade. But if you are a school, aware that the kids in your building are fifth through ninth, for example, you would span both of those products. What we are allowing schools to do is purchase a single whole school license and then take whatever licenses within that whole-to-whole school sale that they need for fifth or sixth grade -- I'm sorry, for fifth grade, they can -- they'll take their Core5 licenses and then six through nine they would take PowerUp. It’s a really -- very elegantly bridges the GAAP in a lot of school buildings on which span those grades. But there are certainly a lot of cases where PowerUp now is being sold itself into a building, and that's always been the case for Core5.

--------------------------------------------------------------------------------

Alexander Peter Paris, Barrington Research Associates, Inc., Research Division - Director of Research and Education & Business Services Analyst [16]

--------------------------------------------------------------------------------

Got you. And as I recall, a site license for Core5 was $10,000. Am I right on that?

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [17]

--------------------------------------------------------------------------------

Yes. The software license is about $8,500. If you purchase a standard implementation service package with that, it adds about $1,400, so that -- to that $9,900 in total. The same would be true for PowerUp.

--------------------------------------------------------------------------------

Alexander Peter Paris, Barrington Research Associates, Inc., Research Division - Director of Research and Education & Business Services Analyst [18]

--------------------------------------------------------------------------------

So in other words, if I took PowerUp and Core5, I'd be looking at $20,000 or does that $1,400 implementation cover both products?

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [19]

--------------------------------------------------------------------------------

Yes. And so -- if you're a district and you have a grade school and a junior high, those would be 2 separate whole school licenses. So that would total -- it would be the sum of both. If you happen to have a building where you have some fifth-graders who need Core5 and some sixth graders who need PowerUp, it would be a single site license. And so would just be $9,900. But it really eases the sale, it eases the implementation for schools, the right thing for students. And it's been really successful and the nice thing that we're seeing with PowerUp, which is brand-new to the market, we introduced it in January, so we look at July sales, which is really when we're getting to book new sales for the coming school year in a large way, PowerUp is more than 20% of our new sales in the month of July, which is terrific for a brand-new product.

--------------------------------------------------------------------------------

Alexander Peter Paris, Barrington Research Associates, Inc., Research Division - Director of Research and Education & Business Services Analyst [20]

--------------------------------------------------------------------------------

Yes. Without a doubt. That's great. And did you say that you're accomplishing this growth in 2018 without significant or material additions to headcount? And as I recall, the sales headcount is in the neighborhood of 45?

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [21]

--------------------------------------------------------------------------------

Yes. We've not in any meaningful way added to the direct sales representative headcount. We have tried to add around the edges to make them more productive through sales support and other areas that we've been able to pretty meaningfully, as we expected to, improve sales rep productivity this year. Our 2 goals that we've been talking about for the last year or so were to improve productivity in the business through sales rep productivity and through the power of the Literacy product portfolio. And we feel very good about how we're seeing both of those play out right now.

--------------------------------------------------------------------------------

Alexander Peter Paris, Barrington Research Associates, Inc., Research Division - Director of Research and Education & Business Services Analyst [22]

--------------------------------------------------------------------------------

Great. And then I just got a couple on Consumer Language before I get back in the queue. So just to be clear, subscriptions of 1 year or less are now 41% of the total and up from 29% year ago, I think, I saw in the press release. So what are the 59%? Are those lifetime subscriptions?

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [23]

--------------------------------------------------------------------------------

No. Actually, subscriptions of 1 year or less are in fact 58% in the second quarter, Alex. The 39% are 2-year subscriptions. So we continue to have significant interest, if you want, kind of both ends of that spectrum. It's kind of a -- bit of a barbell. So we have a lot of people who are very interested in the kind of the lowest upfront commitment while they try a product. So for us today, that would principally be a 3-month product. But a lot of people want the lowest monthly cost, and the lowest monthly cost would be a 2-year subscription. So we see substantial 2-year interest still. But we've decidedly moved certainly relative to a year ago or 2 years ago to a lot more people kind of at the shorter end of that spectrum, which we really didn't offer until 18 months ago with some.

--------------------------------------------------------------------------------

Alexander Peter Paris, Barrington Research Associates, Inc., Research Division - Director of Research and Education & Business Services Analyst [24]

--------------------------------------------------------------------------------

And do you know a matriculation -- a material matriculation from sort of 3-month subscribers to 2-year subscribers? Or are the majority of your 2-year subscribers initial subscribers?

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [25]

--------------------------------------------------------------------------------

Yes. The majority of the 2-year are initial subscribers. The majority of our 3 months subscribers or 6 month would tend to renew at a life term.

--------------------------------------------------------------------------------

Alexander Peter Paris, Barrington Research Associates, Inc., Research Division - Director of Research and Education & Business Services Analyst [26]

--------------------------------------------------------------------------------

Got you. And then certainly, but do you have a comment on renewal rates on these short-term subscriptions?

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [27]

--------------------------------------------------------------------------------

Yes. I mean, I think what we've talked about -- because as you would expect, renewal rates are very different. For a 3 month, they're much higher than they are for a 2 year. And I think we believe to look at that -- the whole spectrum of renewal rates isn't necessarily that helpful for you. What we really manage for is the portfolio. We're trying to drive the highest number of unit sales at the highest LTV that we can and manage across the portfolio so we have subscription -- initial subscription terms, which have very low renewal rates, as you would expect. A 2-year sub is not likely to renew at a very high rate. Short-term subscriptions, though, have a pretty healthy renewal rate and we're able to maintain, what I believe, certainly relative to the rest of the industry is a very high and net expected long-term value from a customer with that mix, including an awful lot of short term. So we're well above -- we're above $160 of expected revenue from a subscriber today and that includes now approaching 60% of those being short-term subscribers.

--------------------------------------------------------------------------------

Alexander Peter Paris, Barrington Research Associates, Inc., Research Division - Director of Research and Education & Business Services Analyst [28]

--------------------------------------------------------------------------------

That's great. And then -- and what's the price for a 2-year subscription? Somewhere in the neighborhood of $200, I would imagine?

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [29]

--------------------------------------------------------------------------------

Yes. It can range depending on the promotional calendar from $150 to $200 to even more than that when it's at full MSRP.

--------------------------------------------------------------------------------

Alexander Peter Paris, Barrington Research Associates, Inc., Research Division - Director of Research and Education & Business Services Analyst [30]

--------------------------------------------------------------------------------

Well, just my observation there is, at least you got a shot at a renewal. The CDs had no shot at a renewal, right? So...

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [31]

--------------------------------------------------------------------------------

It's too bad. Yes.

--------------------------------------------------------------------------------

Alexander Peter Paris, Barrington Research Associates, Inc., Research Division - Director of Research and Education & Business Services Analyst [32]

--------------------------------------------------------------------------------

Okay. Last question and then I'll turn it over to somebody else is -- and I don't know how you can -- if you're comfortable commenting on this on a public line, but what are you seeing from free competition? Is free competition starting to charge for their product? Or -- they have to get a revenue model at some point, I would think.

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [33]

--------------------------------------------------------------------------------

Yes. Yes. They do. And obviously, the biggest player in the free space, really, the dominant player in the "free space" is Duolingo, who has clearly moved to a -- deciding that it won't be pro bono forever and they will have a revenue model. And it's principally -- I don't -- I'm not inside of that revenue model, but the 2 ways they've attempted to do that are through advertising or if you turn off the advertising -- you can turn off the advertising through the purchase of a subscription. And so that's the way that we've approached it. We have tried to approach it by offering what we think is the best language solution to help you -- to help get you speaking. We believe people find value in that. We believe we can continue to improve the product and people will find increasing value in that, and feel very good about what we're doing and even more excited about what we're going to do.

--------------------------------------------------------------------------------

Operator [34]

--------------------------------------------------------------------------------

Our next question comes from Steven Frankel with Dougherty.

--------------------------------------------------------------------------------

Steven Bruce Frankel, Dougherty & Company LLC, Research Division - Senior VP & Director of Research [35]

--------------------------------------------------------------------------------

I apologize if you covered this, but I did hop on late. I'd like to start with the success of the E&E business, which to me seems kind of a little bit like the forgotten stepchild. What do you think contributed to your ability to strike this large corporate deal? And is that process repeatable, maybe? What kind of pipeline do you have of other large deals for between now and the end of the year?

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [36]

--------------------------------------------------------------------------------

Yes. Thank you, Steve. So 2 things, I mean, I think there were 2 things we had to do fundamentally. First, we had to fix the product. And we believe we did that. I can't mention it in the call, we actually competed for this very same client 5 years ago and lost to one of the biggest competitors in space and a good one. We competed again this year with a new product, new -- relatively new to us in Catalyst, which provides a comprehensive suite of content as well as access to tutors. And the one thing that differentiates us, in this case and in a lot of cases, is access to software content and tutors in the other languages in addition to English. So those world language -- because we can offer those. And a lot -- not a lot of people do. A lot of people focus on what you -- if you're going to pick one thing, you focus on English. But because of the comprehensive suite we have in both tutors, in software, and the fact that we can offer multiple languages, that's a real positive for us in cases like this where we're serving a global client who has multiple needs. And frankly, the other thing we needed to do is we had to set our sights a little bit higher and have the right team in place to go after complicated, multinational corporate deals. These are not easy. The lead times tend to be a bit longer. But they're very, very satisfying when you can get them. I think it's a clear demonstration of what we can do not just in E&E, but ultimately I think what we can do in our consumer business as well. We are absolutely working on more. This is the largest deal in our history. We won't often be having deals that are this large, but we feel really good about the fact that we were able to bring it in and we look forward to being with this partner for some time to come.

--------------------------------------------------------------------------------

Steven Bruce Frankel, Dougherty & Company LLC, Research Division - Senior VP & Director of Research [37]

--------------------------------------------------------------------------------

Would you say how long this contract was for? Is this a multiyear deal? And how long does it run?

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [38]

--------------------------------------------------------------------------------

I did not. It is a multiyear deal. That's probably all I should say.

--------------------------------------------------------------------------------

Steven Bruce Frankel, Dougherty & Company LLC, Research Division - Senior VP & Director of Research [39]

--------------------------------------------------------------------------------

Okay. And then switching to Lexia. I see -- you always disclose the renewal rate, which you do on kind of a school basis, but given your move to multiple products, could you just give us a sense in general on how deal sizes are growing year-over-year?

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [40]

--------------------------------------------------------------------------------

Yes. I mean, we -- the way we really think about it, and you're right to ask that question, is one of our goals is to increase the lifetime value of our customer. And increasingly those customers are district-level customers. And we're looking to do that through increasing penetration of schools in the district, right? And so typically we're not -- at least to date, typically, we're not selling multiple products into the same school. But we are able to penetrate more school buildings as Core5 has proven to be successful into more grade schools. And with PowerUp, we have now an easy transition into middle school, certainly, and in some cases higher than that. But really that middle school is the next step for us. And so that opens up a whole group of potential needs, use cases for us that we haven't been able to really access before. And frankly, it's a market that is underserved. And as the nonproficient eight grader, I talked about the fact that 2/3 of eight graders are struggling readers, nonproficient readers. That's not a market that is well-served. And we believe there is a great opportunity and a great need to serve that with PowerUp. We haven't talked about it publicly. I would tell you, the goal is to improve the lifetime value of each of the districts we're in, and we're doing that and feel very good about the direction in that. Feel very good about the addition of PowerUp to the portfolio partially powering the ability to do that.

--------------------------------------------------------------------------------

Steven Bruce Frankel, Dougherty & Company LLC, Research Division - Senior VP & Director of Research [41]

--------------------------------------------------------------------------------

Okay. And then on the consumer business side, I heard you talk about reducing expectations due to the retail portion. But if you look at the business that really matters, where you're really focused, the App Store mobile focus business, how did that perform relative to your expectations? And kind of what's the next step to fine-tune that business?

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [42]

--------------------------------------------------------------------------------

Yes -- no. A really good question. That business, as an ecosystem, if you look at mobile and web together, as your question stated, performed absolutely in line with our expectations. I would say, there's maybe a little more of a mix towards mobile than we expected. Again, that's where our customers are moving and so we're happy to move there with them. And there was a little more of a mix towards shorter-term subscriptions that we might have initially expected as well. And to some degree, those 2 things -- to some degree, those 2 things go hand-in-hand. Mobile tends to have shorter-term subscriptions. But the unit growth we feel very good about in that we are able to maintain solid LTVs in that. And we did that against the backdrop where -- and I've talked about this in past, they didn't really go into too much detail here. We did that against the backdrop where we're still -- on a net basis, we're still running off a lot of 3-year subscriptions that were originally purchased in 2015, when that was really the only subscription term we had. That was the primary one we were selling, and 2-year subscriptions from 2016 when that was really the primary subscription term we had. Those are running off this year. And so we're fighting against that and still growing units and I feel good about that. Going forward, the keys are continuing to optimize the funnel, allowing customers to have a better experience when they onboard, so that they want to stay with us and we know if they use the product, they'll stay with us. And so we're trying to ease that onboarding experience and the initial experience they have. We're working on some really fun stuff, which we're looking forward to sharing with you in November at our Investor Day. And then over time, we'd like to look for ways to improve the LTV, at least, for some customers, if not for everyone. And I think we'll have more to talk about that in the future as well, but not today.

--------------------------------------------------------------------------------

Steven Bruce Frankel, Dougherty & Company LLC, Research Division - Senior VP & Director of Research [43]

--------------------------------------------------------------------------------

Okay. Great. Congratulations, especially on achieving positive EBITDA. Not easy given the headwind you have in the consumer business.

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [44]

--------------------------------------------------------------------------------

Thanks, Steven. And thank you for joining us. We really appreciate that you've picked up coverage and we're happy to have you, I believe, on your first call, so welcome.

--------------------------------------------------------------------------------

Operator [45]

--------------------------------------------------------------------------------

Our next question comes from Kevin Manthie with Lake Street Capital.

--------------------------------------------------------------------------------

Kevin Manthie, [46]

--------------------------------------------------------------------------------

A lot of my questions have been answered, but if you just go back to Literacy for a second and kind of maybe just briefly touch on what you think of the sales cycle or the seasonality of sales changing from Q2 into Q3.

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [47]

--------------------------------------------------------------------------------

Sure. Yes. Thank you, Kevin. Yes. It's been a -- in the 300 years I've been here, it's been a pretty decided change. It was always -- Q3 was always the largest quarter. But Q2 was material and still is, especially June. But it's really become a Q3-focus business, we believe, driven by a couple of things: one, schools have learned that what they're buying is a software license and that software licenses tend to be annually renewable. And you renew, you purchase -- you might purchase it, for example, in June, the end of the fiscal year. But when you go to renew it, you're really going to renew it as part of your operating budget, which frees up on July 1 for most schools as they begin the new school fiscal year. And so it moves into that operating budget purchase cycle. And so we see very large Julys now and very large Augusts and Septembers as well. Interesting fact, as I said, July this year was 40% larger than July of last year, which was our largest previous month in the history of the company. If you looked at July of this year, it was just about $1 million short of the first 6 months of this year, so gives you a sense of how decidedly the business is moving into the third quarter. So it's a substantial shift in the timing of the business, which has a lot of other applications, right? It moves cash flow later in the year and things like that, too, which is fine. But we're feeling really good about the pipeline and the direction of the business that we see right now.

--------------------------------------------------------------------------------

Kevin Manthie, [48]

--------------------------------------------------------------------------------

Okay. That's great. And I mean, could it be a little bit of it you're dealing with bigger kind of districts or bigger animals, too? I mean, is that some of it? Are you approaching these bigger guys like California, example, as one in a different way? Are you going to have to throw more seasoned salespeople at it? Or how are you kind of going about that as the doors to these bigger opportunities are open to you guys?

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [49]

--------------------------------------------------------------------------------

Yes -- no. Good question. So later in the year last year, we brought on a couple of very senior folks to help us with national accounts and are beginning to create kind of a national account sales structure. We already have a structure where our account executives focus on the largest districts and largest opportunities in the country and we have account managers who focus on smaller districts. Both are incredibly important to us. But we are -- we -- because of the portfolio we now have and the opportunity that we see, we are clearly focused on bigger opportunities than we have been in the past. But I think we see even in smaller districts, this kind of move because we're becoming more central to curriculum, we're not supplemental anymore. In many, if not most cases, we -- Core5 is central to the curriculum of a classroom. It is how kids are learning to read with the teacher. We're moving into the operating budget as opposed to the supplemental purchase at some other point in the school year. And those -- again, those operating budgets free up in July and tend to get -- and those purchases tend to be made in kind of July, August, September time frame.

--------------------------------------------------------------------------------

Kevin Manthie, [50]

--------------------------------------------------------------------------------

Okay. Awesome. And then last one for me that -- I know it's a ways out, but that 2020 cash number, that 2020 targeted cash number of $100 million, what are the kind of initial thoughts there for use of that? Or what are you guys toying around with?

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [51]

--------------------------------------------------------------------------------

Yes. I mean, I think we've always said that if we kind of roll up the models as we had them to begin this year when we shared that, that's where we would be. Whether that's ever actually on the balance sheet or not, who knows, I wouldn't. I would love for us to find opportunities to invest in this business, the business we believe in so much and believe in the leadership of this business. But if we cannot find those opportunities, either internally, as we did for example with the introduction of PowerUp and the Literacy business, which are additional products in K-12 or additional products in our language business, we will certainly remember who our owners are and do what's right by shareholders in terms of looking at smart returns of capital as well. But look, my first goal is to look for opportunities to invest in this business in smart ways that will accelerate the top line and improve the net present value in the business overall, which is ultimately what we're trying to create.

--------------------------------------------------------------------------------

Operator [52]

--------------------------------------------------------------------------------

Our next question comes from John Lewis with Osmium.

--------------------------------------------------------------------------------

John Hartnett Lewis, Osmium Partners, LLC - Managing Partner, CIO, and Co-Founder [53]

--------------------------------------------------------------------------------

I mean, it's really -- So I guess first off, over the next basically 30 months, you're guiding to put $80 million in cash on the balance sheet. And I think just looking deeper into the underlying value of these assets, we think they're radically undervalued. I mean, I think we've looked at the peer group and for annual recurring revenue with businesses of better than 80% gross margins and 90% renewals traded 10x annual recurring revenue and Rosetta is at about 2.5x, and certainly Lexia has an industry-leading growth rate. I think if you peel back the onion a little bit deeper, for 100% SaaS-based companies, they're 4x to 5x sales, we're at 1.5x. And if you look at 12 public and privately disclosed transactions, they're all in the 4x to 8x -- 4 to 8 multiple of revenue. And so I think obviously, the space is white hot with KKR, Vista, Google Capital, Union Square Ventures in the space. And I guess, my question here is, why not both aggressively repurchase stock. I mean, all of these metrics basically gets you to an $800 million to $1 billion valuation, and we've got around a $300 million market cap. So we feel wild discount between private market values and where you are in the public markets. And I think you and the team at Rosetta have just done a absolutely incredible job getting us to this spot. But we'd love to see capital return through buybacks and hopefully some attractive reinvestment bets. So just curious, your thoughts there.

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [54]

--------------------------------------------------------------------------------

Yes. Look, I think you have clearly highlighted the 2 opportunities that we have. To date, we have afforded ourselves the opportunity to invest significantly in our Literacy business, and I believe that's why we've been able to grow that business 350% in the 5 years it's been part of the company. And I think there will be opportunities to continue to invest in our K-12 business. I alluded to one on the call, which we'll talk about more at our Investor Day, which is this huge need to help English Language Learners in schools in the U.S., where -- which we serve. But I think there's some really neat things we can do and we're going to talk to you about that when we come together on November 6. I think with Matt's leadership and the team we now have in place in the language side, I think there's some really exciting investment opportunities as well to take advantage of the fact that we have 80% aided brand recognition in the U.S. How many companies can say that, let alone language learning companies? We talk a lot about some of our competitors in the space, and we should, but there's nobody that can touch 80% aided brand recognition in the U.S. and we have pretty good brand recognition outside the U.S. as well. And so I view it as my job to have a dialogue with you as investors and we'll do part of this at the Investor Day and talk about some of the investment opportunities we see in the business, but I also view it as our job to the extent that we are not able to fully invest that money in a way that will create value for all of us to over time return that capital to shareholders. Like, we are in a seasonal business, right? We're at $20 million in cash. At the end of June, that's going to start to grow. That $80 million you mentioned, hopefully, $25 million of that's going to come in the next 5 months. And so we have to be sensitive to that. But I'm a believer in this business and believe (inaudible) what we can do with this. And again, my first goal is reinvestment, but if that -- those opportunities aren't there, it is reinvest in the stock.

--------------------------------------------------------------------------------

John Hartnett Lewis, Osmium Partners, LLC - Managing Partner, CIO, and Co-Founder [55]

--------------------------------------------------------------------------------

I appreciate that. I think just to put a little finer line on it. I mean, I'm just going through my comp list. Renaissance went out -- Renaissance Learning went out at 4.2x sales. Archipelago at 4.2x sales. Renaissance was sold a second time at 5.3x sales. Vista bought Powerschool for 3.5x sales, and let's see, Vista also merged Powerschool and Onex and its 7.5x sales earlier this year. They disclosed that publicly, had a $3 billion valuation on $400 million in revenue. And so -- and then Duolingo just did around, I guess, 20x revenue, right? They disclosed $40 million in revenue, $800 million...

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [56]

--------------------------------------------------------------------------------

As far as I know, it could be an infinite multiple of revenue.

--------------------------------------------------------------------------------

John Hartnett Lewis, Osmium Partners, LLC - Managing Partner, CIO, and Co-Founder [57]

--------------------------------------------------------------------------------

Yes. It's -- I'm not complaining. I'm just really observing about just -- it's a wild, wild discount to literally everything in existence. If you look in annual recurring revenue from public companies, M&A and especially recently M&A, I mean, it's just like 6 ZIP Codes out of -- and like you said, you have Lexia is blowing off the doors and the best consumer brand in the business. So I know you guys are doing a good job. I'll get off the soapbox, but I definitely feel...

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [58]

--------------------------------------------------------------------------------

So here's the thing I would add, because I -- and I'm passionately agreeing with you. And which is why I'm really excited about investment opportunities when we have them, because if I can smartly invest, for example, in a K-12 business that creates revenues, which can over time be capitalized not just at our multiple, but what our multiple should be over time, that arbitrage, if you will, to spend some product investment dollars to then feed into a terrific sales force with a growing footprint around the country and this is specific to K-12. I would love to take advantage of those opportunities, and we'll talk to you about some of those. And same old story on the language side. I think we're in a much better position now than we have been in the past to begin to grow that business again with a smart, capable management team who I can think can take it to much better places where we will be afforded those -- a much more appropriate multiple. We don't value ourselves. We appreciate you doing it, but we certainly believe there is a more appropriate multiple than where we are today.

--------------------------------------------------------------------------------

Operator [59]

--------------------------------------------------------------------------------

At this time, I would like to turn the conference back over to Mr. John Hass for closing comments.

--------------------------------------------------------------------------------

A. John Hass, Rosetta Stone Inc. - Chairman, President & CEO [60]

--------------------------------------------------------------------------------

Thank you, everybody, and thank you for questions. I do hope many of you are able to join us for the Investor Day either in New York City or virtually. We're really excited about the vision we want to share with you on the Literacy business, a business that, as we've said, sits in the sweet spot of K-12 curriculum. It's really where literacy sits as well as some of the opportunities that we've seen in K-12 generally.

As I mentioned, if we achieve our 2018 sales goals, Lexia would have grown 350% in the 5 years since it’s compart of Rosetta Stone. We're getting momentum back in the language business. It took a little bit longer because we had to go through and change the entire business model and the product portfolio, but I feel the momentum building there as well. It's transitional, so tends to temporally hide some of the progress, but it's coming. And behind all of that, we have a market-leading products and a brand which is unmatched. And overall, a company with $190 million in sales this year, almost all of which are subscription-based and which is beginning to grow. And then if we can take that through a business with 80% gross margins, we'll turn that growth into cash flow going forward. So thank you, all, for joining us, and we look forward to seeing you in a few short months with some exciting things to talk about.

--------------------------------------------------------------------------------

Operator [61]

--------------------------------------------------------------------------------

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. And thank you for your participation.