We are changing the way the world learns languages. —Tom Adams
It was mid-April 2009. Tom Adams, president, and CEO of Rosetta Stone, Inc. (Rosetta Stone), the language learning software company, reached for his iPhone to contact Phil Clough of private equity fund ABS Capital. Adams and Clough had been discussing plans to take Rosetta Stone public for some time. The wait was finally over.
In the wake of the 2008 financial crisis, the market for initial public offerings (IPOs) evaporated. By early spring the market was showing its first encouraging signs. Just a week prior, Chinese online videogame developer Changyou.com had listed on the NASDAQ at a price to EBITDA of 6.5 times followed by a one-day jump of 25%, and the online college Bridgeport Education was currently circulating its plans to go public at a range of 10 to 12 times EBITDA.
Having received preliminary approval of its registration filings with the U.S. Securities and Exchange Commission (SEC), Rosetta Stone was authorized to sell 6.25 million shares, a 30% stake in the company. Exhibits 1 and 2 provide financial statements from Rosetta Stone’s IPO prospectus, required by the SEC to inform investors about the details of the equity offering. Half of the shares were to be new shares and the other half were shares to be sold by existing shareholders. Rosetta Stone management had circulated an estimated price range of $15 to $17 per share, representing a price to EBITDA of about 8 times. Demand for the shares was strong, and some analysts believed that Rosetta Stone was leaving money on the table. Yet with world financial and product markets still in turmoil, there was a strong case to be made for prudence.
Economic Conditions
The previous year had been a dramatic one for the world economy. Prices on global credit and equity markets had been in free fall. The U.S. equity market was down more than 50% from its peak in October 2007 (see Exhibit 3 for details of the recent price history of U.S. equity market returns in total and for select industries). The collapse of world financial markets had preceded deterioration in economic activity worldwide, including dramatic shifts in real estate values, unemployment levels, and discretionary consumer spending.
The severity of economic conditions had prompted massive intervention by world governments with dramatic policy changes, particularly by the U.S. federal government. The economic and political conditions were frequently compared with those of the Great Depression of the 1930s. With the crisis in full swing, investors had flocked to U.S. Treasuries for security, pushing down yields on these instruments to historic lows (see Exhibit 4). Heightened investor risk aversion had expanded the risk premium for all securities. The general market risk premium was currently estimated at 6.5% or 8.5%, respectively, depending on whether long-term or short- term government yields were used in estimating the risk-free rate.
Rosetta Stone
In the 1980s, Allen Stoltzfus, an economics professor, real estate agent, and history buff, was frustrated with his slow progress in mastering the Russian language. He was enrolled in a conventional classroom Russian course but found it much less effective than the process he had used to learn German while living in Germany years before. Seeking to produce a more natural language learning method, Stoltzfus envisioned using computer technology to simulate the way people learn their native language—with pictures and sounds in context. Rather than learning the language by translating one language to another, his approach would be to use electronic technology to encourage people to think in the target language from the beginning. He sought the aid of his brother-in-law, John Fairfield, who had received graduate training in computer science. Together they explored the concept of how a computer could be made to facilitate language learning. Stoltzfus and Fairfield founded Fairfield Language Technologies in Harrisonburg, Virginia, in 1992. The emergence of CD-ROM technology in the 1990s made the project feasible. The company released its first retail language training software product in 1999 under the name Rosetta Stone.
The Rosetta Stone series of CD-ROMs provided users with an effective way of learning new languages. The software utilized a combination of images, text, and sound to teach various vocabulary terms and grammatical functions intuitively by matching images with the spoken word. Following the way children learn their first language, the company called this method of teaching languages the Dynamic Immersion method: “dynamic” because digital technology and the teaching method powerfully engaged the learner in an interactive learning process, and “immersion” because learners anywhere, from any language background, started at the very beginning and studied exclusively in the target language. A recent research study provided scientific evidence that the language test scores of students that completed 55 hours of Rosetta Stone training performed comparably to those who had completed an entire semester of a good quality college language course.4 Rosetta Stone users were broadly satisfied with the experience and regularly recommended the software to others.
After focusing initially on school and government sales, the company began aggressively pursuing the retail market in 2001. Following the death of Stoltzfus in 2002, the company hired an outsider, 31-year-old Tom Adams, as chief executive. Adams brought an international dimension to the small-town, rural company: A native of Sweden who had grown up in England and France, he was fluent in Swedish, English, and French. He had studied history at Bristol University in the UK and had earned an MBA from INSEAD in France. Prior to arriving in Harrisonburg, Adams had been a commodity merchant in Europe and China.
Adams got right to work by entering new markets and scaling up the current business; from 2004 to 2005, the revenues of the company nearly doubled, from $25 million to $48 million. Acknowledging the need for capital and professional support as the company expanded, Adams solicited a capital infusion from the private equity market. In 2006, two firms, ABS Capital Partners and Norwest Equity Partners made major equity investments in the company. As part of the recapitalization, the name of the company was changed from Fairfield Language
Technologies to Rosetta Stone, Inc., to match the signature product. Over the ensuing two years, revenue continued to expand aggressively, rising to $81 million in 2006, $137 million in 2007, and $210 million in 2008. Since Adams’s arrival, the compound annual growth rates of Rosetta Stone’s revenue and operating profit were at 70% and 98%, respectively, and the company employed over 1,200 people. By early 2009, Rosetta Stone was the most recognized language learning software brand in the world. Millions of language learners in more than 150 countries were using the Rosetta Stone software. The company offered self-study language learning solutions in 31 languages to its customers. (Exhibit 5 lists the language training software currently offered by the company.) In 2008, approximately 80% of Rosetta Stone’s revenue was accounted for by retail consumers, and 20% by institutions. Institutional customers included educational institutions, government and military institutions, commercial institutions, and not-for-profit institutions.
In a few short years, Rosetta Stone had successfully developed a strong brand; its kiosks with bright yellow boxes had become an institution in U.S. airports, and its print advertising in travel publications included a popular print ad of a young farm boy holding a Rosetta Stone box, the copy reading, “He was a hardworking farm boy. She was an Italian supermodel. He knew he would have just one chance to impress her.” The unaided awareness of the Rosetta Stone brand was more than seven times that of any other language learning company in the United States. Leveraging a strong brand, steady customer base, and diverse retail network, Rosetta Stone maintained positive profitability in 2008 despite the severe economic downturn and, in both average orders of bundled products and services and in units sold, even had experienced increases.
The company expanded its product line by increasing the number of languages and levels offered and broadened the language learning experience by introducing Rosetta Studio and Rosetta World. Rosetta Studio allowed each Rosetta Stone learner to schedule time to chat with other learners and with a native-speaking coach to facilitate language practice, motivation, and confidence. Rosetta World connected a virtual community of language learners to practice their skills through a collection of games and other dynamic conversation opportunities. Adams envisioned a substantial growth trajectory for the company with a multitude of ways to leverage its novel learning technology and expand its geographic reach. With a fixed development cost, Adams expected the strategy to continue to increase company operating margins and expand revenue, but he recognized that, as the company continued to show strong profit and growth, the incentive for competition to attempt to gain market share would intensify. Exhibit 6 provides three video excerpts of an interview with Adams in which he describes the future of Rosetta Stone.
Industry Overview
The worldwide language learning industry was valued at more than $83 billion, of which more than $32 billion was for self-study learning, according to a Nielsen survey. The U.S. market, from which Rosetta Stone generated 95% of its revenue, was estimated to be more than $5
billion for total language learning and $2 billion for self-study learning. The total language learning market was expected to expand as proficiency in multiple languages was becoming increasingly important due to trends in globalization and immigration. The self-study market, particularly through electronic delivery, was expected to dominate the industry expansion given that self-study was increasingly accepted by language learning and travel enthusiasts.
The language learning industry had historically been dominated by specialized language schools that taught languages through conventional classroom methods. The largest player in the market was privately held Berlitz International. Berlitz taught languages in its classrooms using the Berlitz Method of Language Instruction, which advocated immersion in the target language, among other things, and according to company literature, offering programs and services through more than 470 centers in more than 70 countries. Auralog, a French company, was another important competitor in the industry. Both Berlitz and Auralog offered electronic software packages that provided quality language training software.
As had the Rosetta World product, businesses such as LiveMocha, Babalah, and Palabea had also adopted a social media approach, connecting language learners through the Internet, but these sites tended to be secondary enrichment sources for language learners.
Major software companies with deep pockets represented the most important potential threat. Although the novelty of Rosetta Stone’s approach shielded it from many of the existing players in the industry, the entry of a company such as Apple or Microsoft into the language learning market had the potential to thwart Rosetta Stone’s aspiration of dominating global language learning.
Pricing the Rosetta Stone IPO
Adams had a preference for a strong balance sheet and cash position for the company. As a private company, corporate investment was limited by the amount of capital the company could borrow from private sources. With constrained resources, Adams was concerned that Rosetta Stone was an attractive takeover target for a company with the needed resources. Led by Phil Clough at ABS Capital, the private equity investors were anxious to recognize the gains achieved through the Rosetta Stone investment.
In March, the board had discussed the matter and yielded the IPO decision to Adams. Despite the uncertainty of taking a relatively young company public in the most volatile markets in decades, Adams was inclined to move forward with the deal. The fourth quarter financials continued to show impressive performance, with a 53% expansion in revenue despite the global economic contraction. (Exhibit 7 details the historical financial performance of the company along with historical internally generated values of Rosetta Stone shares.) Advisors at Morgan Stanley had shared their view that Rosetta Stone was one of only a handful of companies that currently had a shot at a successful IPO. Senior management had been preparing the systems and organization of the company for public company status for years.
Adams saw the IPO event as a significant opportunity to establish business credibility and build the Rosetta Stone brand in a global marketplace. His decision was to launch.
Over the following week or two, senior management and bankers visited prospective investors on the east and west coasts of the United States and in Europe. The investor response was highly enthusiastic, with investors commonly asking to “max out” their allocation in the deal. By the end of the roadshow, Morgan Stanley reported that the book was more than 25 times oversubscribed, meaning that the underwriters maintained orders for 25 shares for every Rosetta Stone share being offered in the deal.
Adams was delighted that many investors appeared to share his vision of Rosetta Stone’s unique capacity to play a substantial role in the global language learning market. Such a trajectory implied revenue growth rates of 20% to 35% for some time. Other analysts were more skeptical, predicting revenue growth of around 15% for the next five years and then tapering down to a long-term growth rate of 3% to 4%. Adams believed that the operating leverage in the organization allowed margins to continue to improve for some time; others believed that competitive pressure would soon drive margins down. (Exhibit 8 provides one view of how the financials were expected to play out in the years to come.) In the debt market, Rosetta Stone faced a prevailing borrowing rate of about 7.5%. The marginal corporate tax rate for the company was 38%. Exhibit 9 details the current ownership structure of the company and details the new shares to be sold in the offering, which would grow the total number of shares outstanding from 17.2 million to 20.3 million.
Comparable multiples played an important role in the valuation of IPO firms. Exhibit 10 provides financial data on a broad set of industry comparable firms. Adams liked K12 Inc. as a comparable match but acknowledged that no other firm perfectly matched Rosetta Stone’s business strategy, skill set, risk profile, or growth potential. Still, there was some debate regarding whether Rosetta Stone would be positioned as a technology company or an educational company. See Exhibit 6 for a link to video excerpts of Adams and Clough discussing this topic.
To avoid the dilution of the value of securities of pre-IPO investors, it was appropriate in pricing IPO shares to divide the total pre-money equity value of the firm by the pre-money shares outstanding. In the case of Rosetta Stone, the number of pre-money shares outstanding was 17.19 million. Since the pre-IPO investors held a claim on the ongoing business, a valuation based on the ongoing business represented a pre-money valuation. Valuations based on post- money shares required adding the value of the new IPO shares to the ongoing business valuation prior to dividing by the post-money shares.
Questions
(1) Using the data provided, including comparables data, explain the assumptions you made for the risk-free rate (Hint: Exhibit 4). How did you use the comparable firm data (Exhibit 9) in this analysis? (15 points)
(2) As an alternative to discounted cash flow, use the comparable firm data for EBITDA multiples to estimate aftermarket value and aftermarket price per share. (20 points)
(3) Prepare a regression-based income statement projection for the next 5 years in Excel and prepare a common size income statement for the years prior to the IPO (Hint: see class 10 video). Discuss your findings. Do you see any evidence of scale economies or other factors that could affect your assumptions of future profitability? (30 points)
(4) Using the given cash flow projection in Exhibit 10 to prepare a discounted cash flow valuation (terminal value should be based on perpetuity growth method and Exit EBITDA Multiples) for Rosetta Stone and prepare the sensitivity test on both terminal growth rate and Terminal EBITDA Multiples. (Hint: Review the DCF templates uploaded in class 8, you are only required to fill in the blank cells in the right-side table) (35 points)
- Rosetta Stone Pricing The 2009 Ipo We Are Changing The Way The World Learns Languages Tom Adams It Was Mid April 2009 1 (20.83 KiB) Viewed 34 times
- Rosetta Stone Pricing The 2009 Ipo We Are Changing The Way The World Learns Languages Tom Adams It Was Mid April 2009 2 (16.17 KiB) Viewed 34 times
- Rosetta Stone Pricing The 2009 Ipo We Are Changing The Way The World Learns Languages Tom Adams It Was Mid April 2009 3 (10.93 KiB) Viewed 34 times
Done Rosetta Stone Data (2 of 358) Exhibit 1 Exhibit 2 Exhibit 3 Exhibit 4 Exhibit 5 Exhibit 2 KETTLETOS,PC, PRACTIC 4 100 teadlines, al dandan s 111 *8= 5555 ERAGE BA ME.VE BE 1 5185 PER ER AMPON *** *** 9995 X sta $955 1 1 5665 222 Exhibit 7 Exhibit Exhibit
Done Exhibit 1 Exhibit 2 ETTA STINE, IN PR Rosetta Stone Data (2 of 358) Exhibit 3 Exhibit 4 Exhibit 5 Exhibit 6 Exhibit 7 IN 4 AN IN YEAR 3 IN Exhibit 8