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Edited Transcript of RST earnings conference call or presentation 6-Aug-19 9:00pm GMT

Q2 2019 Rosetta Stone Inc Earnings Call

Arlington Sep 26, 2019 (Thomson StreetEvents) -- Edited Transcript of Rosetta Stone Inc earnings conference call or presentation Tuesday, August 6, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* A. John Hass

Rosetta Stone Inc. - Chairman & CEO

* Matthew N. Hulett

Rosetta Stone Inc. - Co-President & President of Language

* Nicholas C. Gaehde

Rosetta Stone Inc. - Co-President & President of Literacy

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Conference Call Participants

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* Huang Howe

Barrington Research Associates, Inc., Research Division - Senior Investment Analyst & Research Analyst

* John Hartnett Lewis

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

* Josh Goldberg

G2 Investment Partners Management LLC - Analyst

* Steven Bruce Frankel

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

* Lasse Glassen

ADDO Investor Relations - MD

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Presentation

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Operator [1]

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Greetings and welcome to the Rosetta Stone Second Quarter 2019 Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Lasse Glassen, Managing Director, Investor Relations. Thank you. Go ahead.

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Lasse Glassen, ADDO Investor Relations - MD [2]

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Thank you. Good afternoon, everyone, and welcome to Rosetta Stone's Second Quarter 2019 Earnings Conference Call. Speaking on today's call will be John Hass, Chairman and CEO. Additionally, Nick Gaehde and Matt Hulett, Co-Presidents of Rosetta Stone; and Tom Pierno, the company's Chief Financial Officer, will also be available during the Q&A portion of today's call.

We have posted to the Investor Relations section of our website at www.rosettastone.com both the earnings release and a slide presentation that accompanies today's call. We've also posted supplemental information and analysis on our website. The supplemental information will not be read on today's call.

I want to remind everyone that as always, there will be elements in 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. These statements are subject to a number of risks and uncertainties that could cause actual results to differ materially. A description of these risks and uncertainties and other factors that could cause our financial results are included in the SEC filings, including our most recent annual report on Form 10-K and quarterly report on Form 10-Q. We expressly disclaim any obligation to update or revise any forward-looking statements except as required by law.

Today's presentation and discussion also contains references to non-GAAP financial measures. The full definition, GAAP comparison 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 the financial reporting before making any investment decisions.

With that, I'll now turn the call over to John.

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

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Thank you, Lasse, and good afternoon, everyone. I'm excited to share with you today the progress we are making in the business, progress demonstrated by a consumer language business that has stabilized with real opportunities for growth in both our core U.S. market and internationally and progress demonstrated by the fact that the small reading business we bought just a few years ago is now a leader in K-12 education technology, with an expanding portfolio of outstanding products and exciting opportunities for organic growth. These opportunities are firmly rooted in the areas that make us a global leader in digital learning. We are a pioneer in educational technology, with over 60 years of combined experience in transforming the way we learn to read English or speak a new language, knowledge that is allowing us to have a positive impact on our society.

Since we are now a 100% subscription-based SaaS business with high net margins, our growth will deliver high levels of incremental cash flow, as demonstrated by our expectation of more than 40% of incremental revenue will fall to adjusted EBITDA this year, and that this will grow next year and the year after. And because we have an iconic brand and have become a scale player in the K-12 space, we have significant opportunities for organic, high-margin reinvestment and growth. As you know, we have said this is expected to produce operating cash flow of approximately $38 million next year and $57 million the year after. In a few minutes I will talk about how we are managing our business and some of the important activities happening now to deliver this growth, but let me begin with an overview of Q2 results.

Total revenue for the quarter were $45.9 million, a 6% increase versus the same quarter in 2018. This is our second consecutive quarter of year-over-year revenue growth following 4 years of declines. Net income for the quarter was a loss of $2.8 million, and improvement from a loss of $4.2 million in the second quarter of 2018. Adjusted EBITDA in the quarter was $2 million versus $1.4 million in the same period in 2018.

Turning to Slide 4, literacy bookings in Q2 were $12.1 million, a 17% increase compared to $10.3 million in Q2 2018, with the increase largely due to some customers renewing in Q2 that had been expected to renew in Q3. As we said earlier this year, we expected the first half of 2019 to be relatively flat with 2018, as the vast majority of new business this year and the renewal of a portion of the business originated in the first half of prior years will be booked in the second half of 2019. Sitting here in early August, we feel positive about our ability to achieve our literacy growth goals, which have us growing bookings by over 25% year-over-year.

Literacy segment revenues grew 19% over the second quarter of 2019 to $15.1 million, while ARR grew 17% to $52.7 million at the end of the quarter. We expect strong revenue ad ARR growth in the literacy segment to continue in the second half of the year as the expected growth in bookings emerges.

2019 is the second consecutive year that bookings growth in the literacy segment will meaningfully exceed GAAP revenue growth. The lag in revenue growth is being driven by the fact that a significant majority of literacy bookings growth occurs in the second half of the year, with most of the revenue recognized in future periods. But all bookings become revenue, and this deferral will help drive revenue growth in 2020 and beyond. Literacy's retention and renewal rates remain strong, while its contribution margin improved to $2.4 million in Q2 2019 from $1.8 million in Q2 2018 as growing revenues continue to be more fully leveraged in the business.

How will we continue our growth? Turning to Slide 5, we are growing our literacy business in 3 ways: first by continuing to expand the number of whole school site licenses that we sell. In the recently completed school year, Lexia was present in over 14,000 schools in the U.S., but only 4,000 of those schools currently have site licenses versus seat licenses, leaving the other 10,000 as opportunities to upgrade to whole school solutions. And because we now have a full suite of literacy solutions, we have the opportunity to sell more than one product to each school or district. Sales of multiple products to a single customer have grown quickly since the introduction of PowerUp, increasing from 131 customers using more than one product at the beginning of 2018 to over 1,800 at the end of Q2.

Turning to Slide 6. Our largest near-term opportunity, however, is to serve more schools and districts where we are already represented. Today we serve over 14% of U.S. public schools, but the total opportunity in the districts in which those schools reside represents over 40% of all U.S. public schools. This 26% of U.S. schools that we aren't yet serving are in districts where we have reference sites and can share data with the decision-maker that demonstrates our ability to help schools in their own districts succeed.

We saw a great example of each of these opportunities in the second quarter, when we closed the districtwide opportunity in one of the largest districts in California. In 2018, this district expanded their partnership with us, moving from 7 Core5 site licenses to 39 Core5 site licenses and 8 PowerUp site licenses. This year, based on the impact we had on student literacy performance and the strong partnership we have built with the district, they expanded to a combined 54 site licenses for Core5 and PowerUp and added the RAPID Assessment. And knowing the importance of this large-scale implementation committed to a 3-year term worth over $1.5 million, we now serve over 36,000 students in the district under a long-term partnership to improve student literacy performance and academic success across all subject areas and equity for lifelong opportunity. Next slide, please.

Consumer bookings of $14.6 million was flat compared to the second quarter of 2018. Consumer revenues of $16.3 million grew 9% excluding Fit Brains as the result of stable year-over-year bookings and the recognition of previously deferred subscription revenue as our deferred revenue balance has grown.

As I previewed on our last call, we were more aggressive in testing new channels of marketing spend in Q2 in order to identify additional avenues for customer acquisition. This included testing nondigital offline media that had higher production costs and larger upfront cash outlays. We have not deployed this type of marketing in a meaningful way in 5 years and believe that with a more stable business, now is an appropriate time to opportunistically try new potentially efficient avenues for growth.

Specifically, in Q2 we spent approximately $1.5 million for a targeted test marketing campaign that launched in mid-May. As expected, this spend lowered our overall Q2 LTV-to-CAC ratio from its recent ranges to 1.5x. Excluding the second quarter brand spend, which had almost no impact on new quarter bookings, LTV-to-CAC would have been 1.8x, in line with seasonal norms. To be clear, this does not mean the tests were not successful, as this form of marketing has a longer return profile, and its benefits were not expected within the quarter. We will measure success on the basis of traffic and bookings uplift as they develop over time as well as the impact on certain important brand attributes, including awareness of our consumer app.

Because it will take time to study these effects, we are not expecting to spend additional marketing dollars on TV brand advertising this year. We will focus on optimizing net LTV, targeting our historical LTV-to-CAC ratios through the remainder of 2019.

Enterprise and education bookings fell to $15.4 million year-over-year, with the decline driven by the absence of any custom content sales in the quarter versus $1.9 million in custom content sales in Q2 of 2018. E&E revenues in the quarter were down 6% due to lower bookings levels in 2018 and the first half of this year.

As we've said previously, the timing and size of custom content contracts are difficult to forecast and predict. In fact, despite the decrease in E&E bookings in Q2, we are raising our bookings guidance for E&E for the full year, as we recently agreed to a $7 million custom content deal. The deal has been signed by both parties, and funding has been secured by our partner. There is a final formal governance step, which means it is not completely finalized, so there is some risk we won't close, but we expect this step to happen soon, and we have included the transaction in our internal forecast and bookings cash and operating cash flow guidance for the year. If it happens as expected, it will be one of the largest single contracts in the 26-year history of Rosetta Stone.

We are honored to partner with another American Indian tribe to preserve and share their language for generations to come. Because we don't begin to recognize revenues in our custom deals until we begin to deliver content, this deal will have no impact on revenues this year.

Let me spend a moment on our thoughts around custom deals generally. We like these partnerships because they leverage the investment we've made in our language infrastructure, support new investment in tools that make the creation of content efficient, have a reasonable margin although lower than selling existing products and are aligned with our mission as a company in an incredibly impactful way. Given their size and unpredictability, we will continue to assume a relatively small amount in our guidance until realized.

Although our contribution margin for the combined language business was $6.1 million or 20% of revenues -- flat compared to Q2 last year -- contribution margin in the quarter was negatively impacted by the $1.5 million incremental test marketing campaign spend, which was reflected as a GAAP expense in the period. Please turn to the next slide.

Total consumer subscribers at the end of Q2 were 533,000, an increase of 28% over the end of Q2 last year and 3% sequentially in the seasonally slower second quarter. Short-term subscribers are those with initial terms of 12 months or less, with 44% of the total, up a bit from 40% in Q2 2018 but stable with the 45% we saw in the first quarter of this year. The year-over-year increase in short-term subscribers led to a slight decrease in the initial average term length to 13.4 months versus 13.8 months, and the average initial selling price to $93 from $112 versus Q2 of last year. Sequentially, each of these metrics was relatively stable.

In order to better analyze the varying dynamics since the consumer transition to a 100% SaaS subscription business, we have focused on estimated growth and net lifetime value added in each period as a key operating metric. As I discussed previously and previewed on our last call, Q2 was impacted by approximately $1.5 million in production costs and variable media spending for our offline media test. This impacted both the LTV created in the quarter, as a smaller portion of our dollars were spent on faster-returning performance marketing and the overall amount of CAC incurred in the period.

Turning to Slide 9. Consolidated revenues of $45.9 million were 6% higher than a year ago. The second quarter net loss was $2.8 million versus a total -- versus a loss of $4.2 million in Q2 of 2018. The improvement in net loss was driven by the increase in revenues and relatively stable expenses. Adjusted EBITDA in the quarter was $2 million, up from $1.4 million in Q2 2018.

Ending cash of $20.8 million included $9.9 million in net borrowings in Q2 2019 to fund our seasonal cash flow point. Net cash and the use of our facility to fund working capital were generally in line with our expectations, as we were a net user of cash in the first half of the year, like other companies with large K-12 businesses. We expect all of our borrowings to be repaid during the second half of 2019. In fact, we started to pay them down in July.

Turning to Slide 10. While we expect revenue growth to accelerate in the second half of 2019, we are slightly lowering our revenue outlook for the year, driven by the expected timing of the realization as revenues of slightly overbookings from E&E, excluding custom content. E&E bookings are expected to come in later in the year than previously expected and consequently contribute less to 2019 revenues or, in the case of a custom deal, contribute to revenue beyond 2019. Because the increase in expected bookings that will occur if the custom content deal is finalized more than offsets the slightly lower expectations for the portion that will be realized as revenues in 2019, we are raising our guidance for consolidated revenue plus change in deferred revenue to $203 million, on the high end. Bookings and revenue guidance for consumer language remain unchanged, with total revenue expected to grow approximately 10% in 2019.

We continue to feel good about the outlook for our literacy business this year. Bookings, revenue and ARR guidance for literacy remain unchanged and represent continued significant year-over-year growth in this part of the business. Deals have continued strong, cost containment and our net income outlook remains unchanged despite the revenue tightening adjustments to the outlook. Adjusted EBITDA is now likely to be closer to $6 million due to the change in our revenue outlook, just partially offset by lower expected expenses.

Finally, we are changing our operating cash flow expectations for the year to a range of $17 million to $23 million and are now forecasting an ending cash range of approximately $38 million to $42 million, with the high end of both representing the expected finalization of the custom content deal. The high end implies approximately $31 million of cash generation in the second half of 2019. Next slide, please.

Looking forward, as shown on Slide 11, we are excited about the opportunity we see to leverage the investments we have made, especially in our K-12 businesses, to drive continued top line growth and earnings improvement beyond 2019. If we achieve our goals, given the high incremental margins in our business, approximately 40% in 2020 and over 50% in 2021 of incremental revenues will become operating cash flow. And because, barring additional new product initiatives, we believe we can hold total R&D and CapEx relatively stable the next few years, the growth in operating cash should largely turn into cash on the balance sheet.

You will hear later about important advancements in Core5 and our language technology stack that will help us continue to innovate and grow. The investments we have made in our language tech stack, for example, are an important step in reducing our maintenance costs and increasing capital available for growth. In fact, we could improve near-term cash flow further, as much of our recent expenditure has been a new product since we completed the rebuild of our language products, but we see exciting opportunities for high-margin reinvestment in the business.

I would now like to spend a few minutes and talk about how we are managing the business, given the growth and cash generation opportunity that we have. Please turn to Slide 12.

I believe there are 4 important factors to understand about our business and the opportunity we have. First, we are a learning company focused on addressing important societal needs. We care about our ESG ratings and other measures of a constituent impact, but our most important measure is the lives we change through language and literacy education. We believe that when we teach a child to read or anyone to speak a second language, we will improve their life. This provides us focus that has made our language and English reading learning solutions standards in the industry.

Second, because we leverage technology to deliver our learning solutions, we have high incremental cash flow margins. This has been clear as operating cash flow improved, even as we invested in building the fixed cost infrastructure of our K-12 business and will become more clear as growth continues in the future.

Third, because we are now a 100% subscription-based SaaS business, our bookings and revenue are more predictable than they have ever been. Approximately 90% of our literacy customers renew at the end of their contract, and in consumer language, approximately one-third of our bookings are now from renewing customers. And critically as a SaaS business, we now have insight into the needs and behavior of millions of learners using our products across our end markets -- K-12, enterprise and consumer. This is a unique position and one we are only beginning to benefit from.

Finally, because of the leadership position we have in each of our businesses and the key investments we have made, from building the Rosetta Stone brand to our presence in 17,000 K-12 schools worldwide, we have very attractive organic investment opportunities. This is especially important as we operate in an industry where many of our competitors are driving growth by paying high multiples to acquire businesses. Though we look at strategic transactions and we'll look to be opportunistic, especially as multiples weaken, I'm excited that we have areas for organic growth, like English language learning in our schools and internationally we have talked about previously and will update you on today.

Before I do that, let me share how we think about investment in the business, because while our K-12 and language businesses have many similarities that benefit us, they also have distinct characteristics that create attractive and complementary reinvestment opportunities. Please turn to Slide 13.

Our K-12 business has a long-term investment and return profile, similar to other high-performing enterprise SaaS companies. World-class products like Core5 and PowerUp deserve large market opportunities with resilient demand, which produce strong retention rates driven by quality outcomes, all of which create high growth in net margins. We invest to build new products and maintain their excellence, but as new business compounds on top of retained customers, we earn substantial incremental cash flow. Despite ongoing investment in current and new products, we are moving into this phase in our K-12 business.

Our U.S. consumer language business, on the other hand, is an attractive but more tactical investment opportunity. The educational goals of our language business are the same as in K-12 -- create solutions that delight learners and providing outstanding outcomes. And like K-12, we have the opportunity to leverage technology with high gross margins to drive attractive incremental net returns.

The way we create demand in our consumer language business, however, is very different. In K-12, we close business by offering highly effective products sold through our largely fixed cost sales force, while in consumer, we have a business driven by an iconic brand with 90% aided recognition and granular incremental marketing. Lead times are shorter, and conversion to paid subscription is responsive to the right stimulation at the right time. We compound the return from this variable marketing spend by recycling it into additional media with a short-term positive return. And if these marginal returns diminish or become too elongated, by reinvesting in long-term shareholder value-creating opportunities. Over the last 5 years, the focus of these investments has been to build our K-12 business.

Turning to Slide 14. Given our long-term compounding opportunity in K-12, it is important to understand how we approach these investments. Our strategy has 4 pillars: build all of our products on our data-sharing and information management platform, myLexia, to enhance its power and capabilities; continually improve the value proposition of our flagship product, Core5; introduce differentiated products and services to meet critical K-12 needs in areas underserved by existing solutions; and ensure that we have the right team with the right resources to be the trusted partner into schools.

So how have we done? In 5 years, Lexia has gone from being a 1-product company to a growing portfolio of world-class K-12 products built on a platform, myLexia, that is implemented in 17,000 schools, a platform that shares with teachers, schools and districts the critical data and information that empowers them to help their students learn.

In 2013 we introduced a new product, Core5, that is setting the standard for personalized reading instruction in our schools. Since then we have continuously improved the value proposition of Core5 to make it more effective for learners and more important to our customers. We introduced a new animation engine to make the experience more engaging, even on the low-end devices often found in our schools, new licensing to allow K-6 schools to use PowerUp in their sixth grade classes at no incremental cost and just last month, the biggest expansion of content and functionality for Core5 since its introduction. More on that in a bit, but all of this was done to make Core5 the reading product teachers demand to have in their classrooms. And while we expect teaching young children to read -- in other words, Core5 -- will always be the primary driver of our K-12 business, there's much more that we have been doing and will do.

In 2016, we introduced RAPID to provide a computer-adaptive screener for K-12 schools. In 2018 we introduced PowerUp for struggling readers in 6th through 12th grades and delivered a great product that fulfilled an unmet need in the marketplace. In fact, in only a little over a year, PowerUp is already used in over 4,000 schools or approximately 4% of U.S. public schools. Please turn to Slide 15 for the most recent analysis of how Core5 is producing these outcomes in our schools.

We've just finalized our annual analysis of the impact of Core5 on closing the reading gap. This year we analyzed almost 900,000 students during the 2018-2019 school year. At the beginning of the year, only 50% of students were working on skills in or above their grade level. That number increased to 91% by the end of the school year. The students most at risk of reading failure, those who started the year 2 or more grade levels behind, 65% gained 2 or more grade levels of skills in 1 year. Sustained growth and achievement like this makes a real difference. And one of the key ways we achieve these results is by building products and implementing them effectively so that they are used with fidelity. Please turn to Slide 16.

I just walked through our most recent efficiency analysis, and last quarter I talked about the cost to individuals and to society as a whole when we fail to teach a child to read at the appropriate grade level at the right time. But even our products won't help if schools don't use them. And unfortunately, one of the failures of the educational technology industry is that most products go largely unused by the schools that purchase them. Here too we are different.

According to a recent study by LearnPlatform, an organization dedicated to expanding equitable access for all students to education technology that works, 63% -- almost 2/3 -- of purchased ed tech product licenses are never activated. Learn reports that therefore 65% of students exhibited 0 or trivial use. Moreover, they found that only 5% of students actually received the full recommended dosage.

By comparison, during the 2018-2019 school year, Lexia customers activated over 80% of the licenses available to them, and over 40% of learners used our software at the prescribed level of intensity, 8 times better than our industry as a whole, a fact that we are extraordinarily proud of. Please turn to Slide 17.

Next year, we will introduce a new product for K-6, Emerging Bilinguals, focused on learning English. Why do we care about this market? First, teaching nonnative speakers how to speak and read English is one of the most difficult problems our schools face, and there is no one from a pedagogy, technology, trust and brand perspective better able to meet this need than we are.

Second, it is a large, fast-growing need. Currently, approximately 10% of public school students are nonnative English speakers. This is expected to grow to approximately 25% by 2025, according to the National Education Association. We also know that if these children are not equipped with appropriate academic English skills, their chances of success in the classroom are diminished.

Third, we have a large adjacent installed base. Core5 already helps emerging English learners to read English, and Rosetta Stone is used in thousands of classrooms to teach English. But we have never offered a solution built for students in schools that specifically focuses on the needs of emerging bilinguals learning English with an emphasis on speaking skills. Like Core5 and like PowerUp, we expect this new product to become the standard in its marketplace, and as it grows, get similarly high gross and net margins. Development is progressing, and we intend to begin sales for this product next year for use in the 2020-2021 school year.

We will have more opportunities like this going forward because we are a trusted partner for our school partners and we know how to build products that work and get used. And we'll do this, knowing that growing high-retention, high-margin revenue streams are attractive to investors, as shown by the very high multiples paid for companies in strategic transactions in our industry. The opportunity to organically build these revenue streams while solving problems is very exciting. And a number of new product releases are demonstrating how we are doing that this year. Please turn to Slide 18.

We just released major upgrades across our entire literacy product line, including important upgrades to myLexia, RAPID, and PowerUp. We also released a brand-new program for teachers, Lexia Academy. Lexia Academy is an amazing e-learning platform that will support our educators' professional growth with resources and strategies to support blended learning, literacy instruction and product implementation. It includes expert videos, dynamic, interactive content and in-depth course material, among other things.

Teaching reading is difficult, and most elementary schoolteachers are not trained in the science of reading, the foundation for knowing how to teach reading. We believe that as Lexia Academy grows, we can better equip teachers to understand the why of reading instruction in there to look forward to be successful in this area.

But our biggest release this year was a significant upgrade to Core5. In fact, this was the largest expansion of capability and content since Core5's original introduction in 2013. The focus of this release was to deepen and broaden the content for older elementary school students in the third through fifth grade.

So while we are rightly excited to introduce a new K-6 English learning product next year, continuing to expand and improve our core literacy product portfolio is critical to continued growth and learner impact, an area of great importance that hasn't been talked about as much as the fundamental change happening with our language technology platforms. Please turn to Slide 19.

Over the last several years, we have been upgrading and migrating our legacy language learning technology platforms to a single technology stack. This effort has included eliminating flash from our products so that they are compatible with modern web browsers and platforms, in addition to finishing the migration of our advanced content from multiple historical acquisitions. We are in the final months of this migration and integration, which will result in our customers having a better experience.

One result of this effort is that we recently upgraded our world-class enterprise product, Catalyst. Our new Catalyst upgrade includes over 2,900 hours of goal-driven curriculum that teaches learners meaningful business and industry language skills. The upgrade includes adaptive assessment technology that aligns to the Common European Framework of Reference for Languages, or CEFR, and a new end-to-end mobile experience for iOS and Android.

More fundamentally, completing this work will now allow our language engineering efforts to focus on more innovation rather than the deflashing and migration work that has consumed much of our effort in recent years. This has been a very, very expensive and not always forward-moving process which we will be happy to complete. Please turn to Slide 20.

As you know, we are testing our ability to profitably meet the needs of the larger language learning opportunity outside the U.S. Our goal here is to leverage our brand, our content and our ability to provide high-quality Rosetta Stone certified online language instructors to create a unique product offering for demanding international customers, and we will approach selling our solution differently from our peers. Our intention is to provide customers the tutoring they want, when they want it, not packages of tutoring sessions sold a year at a time for a high upfront cost. South Korea is our test market, and the offering is now live for Android users in the country. We view this as a test and will treat the investment as such until we learn more about product and pricing fit with the market. Next slide, please.

Finally, the simple formula for our success is that efficacy times scale equals impact. Efficacy without scale creates no lasting impact. Scale without efficacy is counterproductive. Think about the ed tech products I mentioned, sitting unused in our schools. It takes both to impact society, and that is our goal.

Over the last several years, our lack of profitability came from investing heavily in the K-12 literacy business while simultaneously making the necessary technology, marketing and business model changes in our language businesses, like the very large investments that were necessary to modernize our language product platforms and shift to a SaaS subscription-based consumer language business. Now with a scaled and growing literacy business and a modernized and stabilized language business, we have the opportunity to meaningfully improve profitability as we achieve scale.

Our B2B businesses have attractive incremental segment contribution margins of approximately 70% as we leverage high gross margin products and scale distribution. In our consumer language business, we actively manage our variable media spend to produce the highest absolute dollar return to reinvest across the portfolio.

But the opportunity to sell our current products at a high incremental margin is necessary but not sufficient to achieving our ultimate goal. Our presence in K-12 schools and the Rosetta Stone brand are both capable of being scaled beyond our existing products to reach more learners globally.

To ensure that we are appropriately positioned to take advantage of these opportunities, today we are filing with the SEC a $200 million shelf registration statement to take the place of the shelf that expired a few years ago while we were going through the turnaround. While we have no current need or plans to utilize the authorization, I believe it is good corporate practice to have an active shelf registration.

We are confident in our direction and the outlook for organic cash flow generation, but a shelf provides us the flexibility to act quickly if we see the opportunity to invest in our business -- for example, to finance a strategic transaction to leverage our growing K-12 presence. We will be disciplined stewards of your capital, and of course it is possible the shelf will not be used, but I believe we should be prepared for opportunities if they present themselves.

So as we move forward into the critical second half of the year, I feel good about where we sit. We expect to have positive revenue growth and operating cash flow this year. Just as importantly, I am proud of the work we are doing across the company to provide real value to our learners as evidenced by the fact that in a sea of unused K-12 products, teachers and their students make time in their day to use Core5 because they know that if they do, results will follow. That concludes my prepared remarks.

Operator, you can now open the line for questions.

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Questions and Answers

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Operator [1]

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[Operator Instructions.] Our first question comes from the line of Steven Frankel with Dougherty.

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Steven Bruce Frankel, Dougherty & Company LLC, Research Division - Senior VP & Director of Research [2]

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I'd like John to drill into a couple of things at Lexia. The 89% retention rate kind of jumped out to me since that's the lowest it's been in a couple of years, and the 100% dollar-based renewal rate. I would think with the move to multiple products, the dollar renewal rate should start to go north of 100%. So I wonder if you might explain to me what's going on with those 2 metrics.

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

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I'm joined by Tom and Nick and Matt as well. Nick and Matt are on the road. I'll let Nick address that, and if I have anything to add, I'll come back in and do so.

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Nicholas C. Gaehde, Rosetta Stone Inc. - Co-President & President of Literacy [4]

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Steve, it's Nick. Thanks for the question. As you said, 89% is a slight dip in retention rate from what we've seen historically. As I mentioned on previous calls, we are seeing the impact of the end of what we refer to as grandfathered pricing for legacy customers who had bought our products on a perpetual license basis and then moved to subscription. So we've gradually increased prices on the grandfathered licenses over the years, and this year ended that grandfathered pricing. So there are some customers who saw that price increase and decided not to renew.

I agree with you on renewal rates, that they should pick up above 100% as we see the effect of multiple products being sold to the same customer. I think as you know, Q3 is our biggest quarter by far, and so we should start to see the impact of that portfolio selling take place.

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Steven Bruce Frankel, Dougherty & Company LLC, Research Division - Senior VP & Director of Research [5]

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And these grandfathered customers -- could you maybe size that for us in terms of the number of schools? And have we seen the bulk of the drop-off, or is this a headwind that you might see in Q3 or Q4?

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Nicholas C. Gaehde, Rosetta Stone Inc. - Co-President & President of Literacy [6]

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I don't think we're going to see an acceleration, but certainly with grandfathered pricing ending, we are seeing some of the, especially some of the smaller accounts, in some cases not renew. We don't break out the size of that segment, but we'll continue obviously to report on renewal rates and retention rates.

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Steven Bruce Frankel, Dougherty & Company LLC, Research Division - Senior VP & Director of Research [7]

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Okay. And maybe give us, if you can, a flavor for how intently you're focused on districtwide selling in this peak selling system -- season -- and what you think your chances of success are, and maybe some color on that California win that John talked about earlier.

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Nicholas C. Gaehde, Rosetta Stone Inc. - Co-President & President of Literacy [8]

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Sure. So as I've said in previous calls, we've invested in our strategic sales team, the team that is focused on those larger district opportunities, both the team that is responding to RFPs as well as individuals who have experience working at that level, and we are starting to see that pay off. It is a longer game. Some of those, both large district and state-level opportunities, do take years to develop. But we are seeing more 6-figure deals than we have ever seen historically, and I think that's a direct result both of the expanded portfolio and our increased capacity selling at that large district level.

In terms of the California opportunity, a really exciting opportunity to work with one of the, not just largest districts in California, but also a world-class district in terms of their ability to significantly move student performance. They were called out in a McKinsey study as one of the top school districts not just in the country, but in the world. And so to have them not only use our products, but after multiple years of using the products, expand districtwide, I think is a testament to the quality of not just the products we've provided, but the support we've provided as well.

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Steven Bruce Frankel, Dougherty & Company LLC, Research Division - Senior VP & Director of Research [9]

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Great. And on the consumer business, I understand you spent the TV money, and it's an interesting experiment. Do you sense any competitive changes in the market, and do you have any sense for what the right term is for this business today?

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A. John Hass, Rosetta Stone Inc. - Chairman & CEO [10]

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I'll let Matt address that, Steve, but I just want to understand, when you say the right term, what --

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Steven Bruce Frankel, Dougherty & Company LLC, Research Division - Senior VP & Director of Research [11]

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In other words, where do you think the consumer -- how does the consumer want to buy? What do you think their desired term is?

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A. John Hass, Rosetta Stone Inc. - Chairman & CEO [12]

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All right. Matt, would you like to take that?

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Matthew N. Hulett, Rosetta Stone Inc. - Co-President & President of Language [13]

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A couple of things on the spend. I'll kind of address it in 3 points. The spend component was a really interesting test, and as John indicated on the call, we're going to spend some time looking through what the tail looks like on that spend. In relation to the competitive component, we definitely see competition from both the paid and the free side increasing, although conversely, we also see a lot of trial customers coming in from competitors as well. About 44% of our trialists are actually coming in through other products. So we're also seeing kind of category growth from the competition as well, which is, I think, net good news for us. And then lastly, we have seen a small decrease in the initial term length, as indicated on the call -- slightly, from 13.8 months to 13.5.

It's a good question, Steve. I think things are basically stabilizing. The last several quarters have been stabilizing in terms of LTV. The CAC obviously went way down the inefficient road from our current kind of 2:1 ratio that we have due to the brand spend. But I think in general we have been pretty stable, and I expect that to be stable going forward.

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Steven Bruce Frankel, Dougherty & Company LLC, Research Division - Senior VP & Director of Research [14]

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Okay. And then a quick last one. On Live, I think a couple of quarters ago you talked about ending the test some time in Q3 and going out and marketing the product more fully. What do you think the timing looks like now, and when will you move from Android, which historically is a platform that doesn't generate a lot of revenue in app stores, to iOS, where people tend to spend more money?

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Matthew N. Hulett, Rosetta Stone Inc. - Co-President & President of Language [15]

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That's a great question. On the iOS component, we don't have a firm date yet, although that is something we're obviously looking to do. We also have a pretty strong relationship with some of the players in Korea, hence the Android focus. In addition to that, we do have a standalone SKU in the App Store called Rosetta Stone Live that went live, literally, several weeks ago. So we've moved officially not from beta mode into general availability in the Android App Store.

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Steven Bruce Frankel, Dougherty & Company LLC, Research Division - Senior VP & Director of Research [16]

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Okay. Great. And how are you marketing it? Are you just going to leave it to the App Store marketing? Are you doing anything different in creating market to try to generate interest in this?

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Matthew N. Hulett, Rosetta Stone Inc. - Co-President & President of Language [17]

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That's another great question. As you know, we've had strong reseller presence under the Rosetta Stone brand for quite a while, and so we have relatively solid -- not as good as the United States obviously in aided awareness -- but pretty solid in Korea. We're doing both influencer marketing as well as digital marketing as well. And one of the key things we want to do for that business is to be really good at digital acquisition marketing versus the traditional tutoring route of being more offline. And we've seen pretty good early signal around acquiring customers through digital-only channels.

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Operator [18]

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Our next question comes from the line of Alex Paris with Barrington Research.

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Huang Howe, Barrington Research Associates, Inc., Research Division - Senior Investment Analyst & Research Analyst [19]

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This is Chris Howe sitting in for Alex. Leading off and following up on the previous question about the district opportunity in California, can you provide some perspective as to how many other opportunities, maybe not as large, are out there for districts and how we should expect -- how should we look at the backlog for district opportunities versus where it's been historically?

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Nicholas C. Gaehde, Rosetta Stone Inc. - Co-President & President of Literacy [20]

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Sure, I'd be glad to answer that. So as I said on the previous question from Steve, we are seeing more large opportunities than we've ever seen, and many of those are at this district level. We're not providing detail at this point about the specifics of the pipeline but are pleased with the strengthening of the pipeline going into obviously our biggest quarter, and do see the investments we've made in district-level selling and the capacity of the product to work at the district level being something that the market has been looking for and is accepting.

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Huang Howe, Barrington Research Associates, Inc., Research Division - Senior Investment Analyst & Research Analyst [21]

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That's very helpful, and I look forward to that. And my next question is on -- you had mentioned it before about the opportunity set that's out there for emerging bilingual and English language learning students. Could you provide some color on what you're seeing as far as the potential runway for this opportunity? And how is this need currently being met in the marketplace?

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Matthew N. Hulett, Rosetta Stone Inc. - Co-President & President of Language [22]

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Yes, I'm glad you remember the term “emerging bilinguals.” I think it's one of the things that we are focused on, which is different in this industry, thinking about those learners not as having a deficit, but as having a real strength, being dual language learners.

The short answer to how is that need being met in the market right now is not very well. Unfortunately, there are not many products, or whether it's print or digital, that do a good job of supporting those emerging bilinguals, and that's especially true where the bulk of the market is in the K-6 segment, so products that are geared to those young learners that are appropriate for their age and yet build the skills they need to be successful in school and to access the rest of the curriculum. As John said in his remarks, it is the fastest-growing segment of the student population. And we see just a phenomenal opportunity, given our experience both on the literacy and language side and the strength of our brand to meet the needs of those students and meet the needs of schools who are increasingly, I think, struggling with how to help those students succeed.

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Huang Howe, Barrington Research Associates, Inc., Research Division - Senior Investment Analyst & Research Analyst [23]

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Okay. And just a last question here. It's a little outside of the box, but if we were to parse out or decompose the Lexia product line, how would you characterize the rate of adoption or engagement or even the potential for runway that's out there for each of the pieces of the Lexia portfolio?

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Matthew N. Hulett, Rosetta Stone Inc. - Co-President & President of Language [24]

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So as we shared in the presentation and we shared previously, although we are really thrilled with the momentum we have over the past number of years, we still have a lot of runway in terms of the market that is still to be addressed. If you just think again about the districts we're already in, we have enormous opportunity just to expand within that current footprint, in districts where we can actually show data about their students and the performance of those students.

Core5 is in about 14% of the market, and PowerUp, although it has grown really quickly out of the gate, it's only in about 4% of the market. So again, lots of opportunity ahead of us, and I think now that we have a comprehensive K-12 portfolio for curriculum and assessment, we're able to meet the needs of schools much more holistically than we were before. Instead of having a conversation about a given student population and how an individual product can meet the need, we can talk at the district level about all of their literacy challenges and then direct them to the right product, given the things that they're trying to accomplish.

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Operator [25]

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Our next question comes from the line of John Lewis, Osmium Partners.

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John Hartnett Lewis, Osmium Partners, LLC - Managing Partner, CIO and Co-Founder [26]

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I'm very supportive of your strategy and results, so congratulations on getting the company in the right direction. I guess just to follow on Chris Howe's comment on emerging bilinguals -- this is for Nick -- what percentage would you say of U.S. students would fall into the emerging bilinguals category? Is it 5%, 10%, 15%, or just to size that market a little tighter?

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Nicholas C. Gaehde, Rosetta Stone Inc. - Co-President & President of Literacy [27]

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So in terms of students who are identified as English language learner students who are identified in districts and receiving support because of that designation, that's about 10% of the student population and is forecasted to grow to about 25% by 2025, as John mentioned. When we think about emerging bilinguals, it's a broader market than just the students who have been designated as ELs, because there are students who have a certain level of proficiency in the English language that don't qualify them for those services, but they still don't have the capacity to maximize their learning potential. And so we're targeting not just those students who are already in EL programs, but a broader segment of the market.

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John Hartnett Lewis, Osmium Partners, LLC - Managing Partner, CIO and Co-Founder [28]

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Is the per-student spend by districts higher for literacy or emerging bilinguals or in the same bucket?

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Nicholas C. Gaehde, Rosetta Stone Inc. - Co-President & President of Literacy [29]

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It depends on how you break down literacy. So typically, spend on specific student populations, whether it's special ed, Title I or EL, is higher. There are also more funding streams that you can take advantage of, so funding streams both from state and local budgets. But in the case of those specific student populations, federal funding streams as well. And so they tend to be places where schools need to and are willing to spend more money, and the funding is there that allows them to do that.

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John Hartnett Lewis, Osmium Partners, LLC - Managing Partner, CIO and Co-Founder [30]

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Okay. Just to just finish up, so it's 10% of the U.S. student population now, and you think by 2025, it will be 25%? Is that right?

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Nicholas C. Gaehde, Rosetta Stone Inc. - Co-President & President of Literacy [31]

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That's the current projection, yes.

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John Hartnett Lewis, Osmium Partners, LLC - Managing Partner, CIO and Co-Founder [32]

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Okay. Matt, I guess I just had a couple of quick questions for you, really on live tutoring. I get that you're testing it in South Korea, but do you have any targeted -- where you would bring that offering to the U.S. or like a time range or anything?

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Matthew N. Hulett, Rosetta Stone Inc. - Co-President & President of Language [33]

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We don't. We don't this year, John, have stated anything beyond South Korea, although as you know, in our enterprise business we've been doing live tutoring, both one-on-one and group for years, so we know generally where the right places would be to go to next, but we haven't announced anything formally.

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John Hartnett Lewis, Osmium Partners, LLC - Managing Partner, CIO and Co-Founder [34]

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Okay. And then anything, any plans, Matt, on international expansion in consumer? Are there any countries soft-circled on when you would take a more aggressive path there or any color there?

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Matthew N. Hulett, Rosetta Stone Inc. - Co-President & President of Language [35]

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No real additional color. We think that obviously APAC is the largest language learning market by far. It's 40% of overall learners are learning some form of language in APAC, and that's primarily English. So we think APAC's a generally good opportunity. And Korea's been an interesting spot for us because of the relatively high aided awareness of Rosetta Stone, and it's a market that we feel like we can better enter in with not as much capital to be deployed. But I do think APAC in general is a huge opportunity for us.

And our EMEA business in consumer is also something that we spent a little bit more time looking at as well. We've been more U.S.-centric, as you know, in our businesses. Most of our businesses in consumer is United States, so we have been spending more time thinking about different price and offering bundles. But Korea's really the focus right now.

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John Hartnett Lewis, Osmium Partners, LLC - Managing Partner, CIO and Co-Founder [36]

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Got it. Okay. I appreciate that. And then this is just for John. It's a little bit of a longer comment and a question. Frequently on these calls, I bring up, really, what I see as a large gap between the public value of the business and what the business is worth based on comparable transactions. And really, to put an exclamation point on top of it, Barron's highlighted last week that there are pockets of software stocks that are now pushing 20x 2019 revenue without earnings. And you look at Rosetta Stone's guidance of doubling operating cash flow, it puts you in the top 10% of the Russell 2000, yet Rosetta's at about a 90% discount at 2.7x sales. And if you look at the business on a more relevant apples-to-apples basis, you guys are trading for about half of M&A valuations.

Last year Cambian went private at 4.5x sales, Archipelago at 4.2x sales, Renaissance at 4.2x sales. It sold 3 times now privately, and now that Rosetta's a 100% SaaS-based model and it still trades at, say, at least a 50% discount, and since these companies have gone private, I would also think that multiples have done nothing but expand. And I see Chegg's at 13x revenue and 50x cash flow. So I continue to see a really wide gap, and you guys have very solid results of 56% incremental cash flow margins, really relevant products. So I guess the question is where are you on trying to bring on -- several years ago you had 10 analysts covering the company. Where are you in terms of getting more analyst coverage, road shows, and really getting the story out because I don't think it's well followed at all on Wall Street.

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A. John Hass, Rosetta Stone Inc. - Chairman & CEO [37]

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No, and John, we would agree with you. And thank you for the context and color. We're very happy that Steve picked up coverage this year. He's been terrific, I think, in getting the word out and trying to really understand and share the story as he sees it. We are very focused on gaining additional coverage. We'll be at 5 investor conferences over the next month or so. The nondeal road show calendar has been quite long when we've not been in blackout.

So I think bottom line, what we have to do is run the business as best we can, tell the story as best we can and then look for opportunities as they present themselves or as we can create them. I think we're very focused on that. We'll obviously take any help we can get in terms of recommendations for additional coverage. But we are very focused on that.

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John Hartnett Lewis, Osmium Partners, LLC - Managing Partner, CIO and Co-Founder [38]

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Well, John, just to follow up, I have a good friend who's a former CEO, and he spent the last 9 months trying to raise a SPAC looking at software companies and SaaS models and couldn't find anything to buy less than 4.5x to 5x revenue and just gave up. And he had a private equity sponsor, so it is a true outlier to have a -- for the business model you've built and the transition you've made relative to everything else in public equity and private market valuations, I think your stock is considerably undervalued, and congrats on the solid progress.

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Operator [39]

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Our next question comes from the line of Josh Goldberg with G2 Investment Partners.

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Josh Goldberg, G2 Investment Partners Management LLC - Analyst [40]

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I just wanted to talk a little bit more about the selling season in Lexia and specifically some of the big opportunities in Texas and New York. And I have a follow-up.

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A. John Hass, Rosetta Stone Inc. - Chairman & CEO [41]

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Okay. Nick, go ahead.

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Nicholas C. Gaehde, Rosetta Stone Inc. - Co-President & President of Literacy [42]

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Sure. So as you know, we have been focused on the opportunities in specific markets across the country where we see either funding or tailwinds that allow us to drive growth faster than in other potential markets. In Texas, where there's a significant amount of adoption money in play now and for the next 8 years, we have increased the number of sales reps and the marketing activity and are pleased with the kind of momentum we're seeing. Obviously, we are now 1 month into the third quarter and are waiting and working to close a lot of business in Texas.

I will say that one of the things that we are seeing is a fair amount of competition and a fair amount of competition not just from what historically has been our smaller competitive field of digital publishers, but the big publishers as well. What you sometimes see in those big adoptions is people first prioritizing the big core curriculum and then adding in intervention, supplemental and other products after that. So it is a longer game and one that will, I think, pay off for multiple years in terms of the investments that we've made. But we are pleased with the momentum and the return on investment that we believe we'll see in the third quarter coming out of Texas.

New York is a little bit different. As you know, being in New York, it is very much historically a building-by-building sales environment. I think with the new administration, there is a move to centralize some of the authority in the long term, but budgets are still at the school building level. Good news is that we are now on the FAMIS purchasing platform, so all schools can now go into FAMIS and use funding to purchase our programs, and we're seeing continued expansion of the business in New York City as a result of being on FAMIS and, I think, the increased capacity we have in that market.

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Josh Goldberg, G2 Investment Partners Management LLC - Analyst [43]

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Okay. Great. And regarding the contract that you won, just curious. You put a slide in your deck of aspirational goals for 2020 and '21. And the '20 number you didn't change, even though this sounds like a pretty Important deal for you, both on revenue and on margin. Can you just help me understand that a little bit?

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

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Yes, Josh, just generally, we don't revisit our '20 and '21 numbers on an ongoing basis. It's kind of an annual planning cycle. I think even if we did, this deal in and of itself, while important, wouldn't really move those numbers. It's over 3 years, so while it's paid upfront, it's essentially $500,000 a year of revenue recognition. And so it wouldn't have a meaningful impact on that. But even if it did, we wouldn't -- you'll see the same 2020 numbers have been held constant since the first quarter of the year when we came out with them.

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Josh Goldberg, G2 Investment Partners Management LLC - Analyst [45]

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Okay. And last question for me. In terms of some of these specific districts, I think you had a slide about what your opportunities on districts that you're already working with, but you haven't been able to upsell, specifically on Lexia. Can you just talk about where do you see that playing out over the next sort of 6 to 12 months? What I mean by that is it would seem like those are the easiest opportunities is to increase some of those site licenses versus expanding into new ones. I thought the expansion to existing customers would probably be a little bit easier, and I just wanted to kind of hear from you if you think that your north of 30% booking guidance in Lexia is based on new customers versus -- or new districts versus the existing.

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Nicholas C. Gaehde, Rosetta Stone Inc. - Co-President & President of Literacy [46]

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Yes, Josh, so it's really both. Obviously, we see the bigger opportunity in expanding in the footprint we are in right now and have certainly created a sales channel and a strategy to expand in the districts we are in. It's one of the reasons we're so excited now about having a comprehensive portfolio of curriculum and assessment because we can come to the district and talk about their needs, as I said before, from kindergarten through 12th grade. So that is absolutely a focus.

But we also know that we need to continue to drive into districts that we're not in yet, and so we do both. But certainly this year there is more emphasis on expanding in the districts that we are already in than previously.

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Operator [47]

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Ladies and gentlemen, we have reached the end of the question-and-answer session and I would like to turn the call back to management for closing remarks.

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A. John Hass, Rosetta Stone Inc. - Chairman & CEO [48]

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Thank you, operator, and thank you, everyone, for joining us tonight. As I said, we'll be attending 5 investor conferences over the next month or so and look forward to seeing many of you at one of those stops and talking to you over the next period of time. Thank you and have a good night, everybody.

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Operator [49]

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This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.