Rosetta Stone RST – The Negatives Outweigh the Positives

I am willing to bet that once you hear the name Rosetta Stone, you automatically associate it with learning a foreign language. Rosetta Stone has done a tremendous job of marketing, and today, it is the most recognized brand of language learning products in the United States. The results are evident because since 2004, revenues have increased from $25.4 million to $252.3 million in 2009, which represents a tenfold increase.

The company uses a unique method known as Dynamic Immersion to teach adults new languages. This method is modeled after the way children learn, with no grammar or explanation but with practice and context. It uses images, text, and sound to teach vocabulary terms and grammar naturally. Rosetta Stone’s customers include individuals and institutions such as schools, government agencies and corporations.

The company was founded by Allen Stolzfus, after a frustrating experience trying to learn Russian in a classroom setting. He had already experienced learning a second language, German, while living in Germany, and because of this, he believed that immersion was a much more effective method that allowed him to learn in the same way he had learned his native language.

As a result, he came up with the idea to create a system that would simulate the process that he used to learn German through computer technology. However, he needed help and he approached his brother-in-law, John Fairfield, who had an advanced degree in computer science. Unfortunately, this was during the 1980s when computer technology was not as advanced as it is today. Allen had to wait until 1992 for the technology to develop to meet his vision.

Finally, he and John started the company and named it Fairfield Language Technologies. Allen also recruited his brother Eugene Stoltzfus to be the company’s first executive vice president. Soon after, they released their first product and named it Rosetta Stone. This was a clever idea because the Rosetta Stone was the key to finally deciphering Egyptian hieroglyphs, which many scholars had tried to decipher for hundreds of years. With this name they were going to unlock the secret to learning a foreign language.

In 2002, Allen passed away and his brother assumed the leadership role until Tom Adam became the company’s CEO. In 2006, the company was sold to ABS Capital Partners and Northwest Equity Partners who renamed the entire company Rosetta Stone. In April 2009, Rosetta Stone became a publicly traded company with the ticker symbol RST.

The worldwide language industry is big. Based on the Nielsen survey, in 2007, people and organizations spent $83 billion to learn languages. However, the United States represented only 6 percent of the total and Rosetta Stone derives more than 90 percent of its revenues from the United States.

I believe that the worldwide language industry is going to keep growing because our world is becoming more and more globally integrated. People are learning new languages to advance professionally, conduct international business or travel the world.

For many years, Americans didn’t need to learn foreign languages because everyone else was learning English. Now, with business becoming more global with countries such as India and China establishing themselves as major players, many Americans are starting to realize that they need to learn other languages to stay competitive. Even though the language industry is likely to grow worldwide in the future, it will probably grow faster in the U.S. because so many Americans are behind when it comes to learning new languages.

Rosetta Stone’s greatest strength is its brand name. Like I said before, when you hear the name Rosetta Stone, you automatically associate it with learning new languages. For many people who want to learn a new language, Rosetta Stone is most definitely one of the options that they would consider.

The company has done a tremendous job with marketing and has built its brand into a household name. This allows it to charge a lot more for its products than competitors. The company also has a great direct distribution model. While Amazon and Barnes & Noble sell Rosetta Stone’s products, the majority of revenues come from its direct distribution model through the company’s website or mall kiosks. The direct distribution model allows the company to have higher margins than competitors who rely on third-party merchants to resell their products.

While the company’s marketing efforts created the most recognized brand in the language learning industry, I believe that the need to rely so heavily on marketing in order to maintain its brand name and to grow is a major weakness. If the company suddenly stopped its heavy marketing, revenues would deteriorate significantly. This was evident recently when it experienced some marketing mistakes which caused it to miss revenue estimates. I will discuss this issue in the performance section.

Rosetta Stone tries to differentiate itself by teaching the Dynamic Immersion method. While this might be viewed by many people as a strength, it could became a major weakness in the future. Currently, the company is capitalizing on it because when you hear an ad that offers immersion in a new language and describes its method as one that teaches you in the same way child learns, it implies that this is a superior method. However, after using the product, some customers have become more acutely aware that adults do not necessarily learn in the same way that children do. As an adult, you are more likely to benefit from grammar and translation, while children are more like a blank slate, lacking the ability to understand more in-depth explanation. As an adult, you already know a language that can be used as leverage to learn another language.

I can relate firsthand because I had to learn English as a second language. I studied English in Poland before I came to the United States but because I never got any practice and was not immersed in the language, I could barely even say “Hello.” My learning started when I was thrown into a class with Americans. However, it didn’t come without grammar and translation. Every day, I had to go home and use a dictionary and study grammar. The combination of grammar, translation, and immersion made me learn the language. So when Rosetta Stone says that you can learn a language without grammar and translation, I must question it.

Fortunately, for Rosetta Stone, its clients are mainly Americans who are pretty uneducated about the process of learning a new language because most of them have never really had to do it before. Everyone else around the world learned English instead. Now, the world is changing and Americans are realizing that they will have to learn another language to stay competitive. As of now, Americans are still an easy target for companies such as Rosetta Stone whose marketing implies that learning a new language is fun and easy and can be done just like a child. But what happens when Americans realize that learning another language takes a great amount of discipline, time and effort, and learning like a child is ineffective and wastes time? What happens when another competitor with greater financial resources starts running ads telling customers to “learn a language the way it works – like an adult, because you are not a child?” Rosetta Stone is going to have a harder time increasing sales, and marketing dollars will produce fewer and fewer sales.

You might say that Rosetta Stone has tremendous opportunities overseas because it derives less than 10 percent of its revenues from outside of the U.S. I agree with this, but remember – foreigners are not uneducated about the process of learning a new language. Many of them already did it before and telling them to learn like a child might not yield the same results.

As I mentioned before, the company increased revenues from $25.4 million in 2004 to $252.3 million in 2009 which is an incredible performance. Net income increased from $1.9 million in 2004 to $13.9 million in 2008 and dropped to $13.4 million in 2009.

When the company went public on April 15, 2009, it was one of the hottest IPOS of the year. There was so much hype that the stock price increased 39.6 percent during the first day of trading. By May 5, 2009, shares were trading 75.9 percent higher than the IPO price of $18 per share. However, by September 2, 2010, the stock price was below $18 per share. What a disappointment! The reasons were lackluster sales and the departure of two high level executives. The CEO explained that sales were disappointing because of changes in the advertising market. The company usually buys cheap advertising at the last minute on TV and the prices of these advertising spots suddenly increased. As a result, the company cut back on advertising and this hurt sales. This is why I was saying before that its heavy reliance on marketing expenditures is the company’s biggest weakness. The moment it reduces or stops advertising, sales decline.

Rosetta Stone has great brand recognition. It operates in an industry that is likely to grow domestically and internationally. So far, however, it has been a disappointment for the investing community, but if it can continue to grow, it will probably benefit them. For me personally, the negatives outweigh the positives, and I will stay on the sidelines.

Disclosure: The author does not own RST