April 16, 2009, 2:33 pm

RST - Rosetta Stone

RST - Rosetta Stone

RST - Rosetta Stone plans on offering 7.25 million shares (assuming overallotments exercised) at a range of $15-$17. Insiders will be selling 4.125 million shares in the deal. Morgan Stanley and William Blair are leading the deal; Jefferies, Robert Baird, and Piper Jaffray co-managing. Post-ipo RST will have 20.3 million shares outstanding for a market cap of $325 million on a pricing of $16. The bulk of ipo proceeds will be used for general corporate purposes.

ABS Capital will own 25% post-ipo..ABS Capital is also the majority shareholder of 2007 ipo APEI.

From the prospectus:

'We are a leading provider of technology-based language learning solutions. We develop, market and sell language learning solutions consisting of software, online services and audio practice tools primarily under our Rosetta Stone brand.'

RST's language learning approach does not utilize the traditional second language approach of translation or grammar explanation. Instead RST utilizes audio & video to replicate the natural language learning ability that children use to learn their native language. RST calls their proprietary language learning approach 'Dynamic Inversion'. RST currently offers their self-study language learning programs in 31 languages.

Language Learning - Children learn their native language without using rote memorization or adult analytical abilities for grammatical understanding. They learn at their own pace through their immersion in the language spoken around them and using trial and error. They do not rely on translation. Traditionally the majority of second language learning programs in/out of the classroom have focused instead on translation, grammar and rote memorization. The majority of alternative second language courses have focused on in-country immersion and private study, both expensive alternatives to the traditional memorization approach. RST's solution brings the immersion approach to ones computer.

Rosetta Stone solution - As noted above, RST aims to replicate the process in which children learn their native language. The student learns at their own pace. The RST content library consists of more than 25,000 individual photographic images and more than 400,000 recorded sound files. Each language has 1-3 proficiency levels which can be purchased individually or bundled. Individual proficiency's (such as Spanish I) retail for approximately $250 while the complete language bundle (Spanish I, Spanish II, & Spanish III) retails for approximately $550. Each proficiency level offers approximately 40 hours of instruction. In addition RST offers an online peer-to-peer practice environment called SharedTalk, at www.sharedtalk.com, where registered language learners meet for language exchange to practice their foreign language skills. During 2008, RST had more than 100,000 active SharedTalk users.

Effectiveness - According to a self-commissioned study, after 55 hours of Spanish study using Rosetta Stone, the learning was sufficient to fulfill the requirements for one semester of university study.

Sector - RST generates 95% of revenues in the US. The US language learning industry generated $5 billion in revenues in 2007, of which $2 billion was for self-study. Assuming these numbers are correct, RST has approximately a 10% share of the self-study revenues in the US and is the far and away leader in their niche.


Consumer sales accounted for approximately 80% of 2008 revenues. Direct-to-consumer channel sales accounted for 58% of consumer sales. These are sales made via RST's website or or call centers. RST's 145 retail kiosks (located in airports and malls) accounted for 22% of consumer revenues and sales to retailers accounted for 21% of consumer revenues. The bulk of retailer sales were to Apple, Barnes & Noble, and Borders.

Institutional sales accounted for 20% of 2008 revenues. Primary/secondary schools represented 44% on institutional sales, government & armed forces 19%, homes schools 20% and businesses 10% and non-profits 5%.

60% of RST customers earn more than $75,000 annually with 44% earnings more than $100,000. In a self-commissioned study, 92% of respondents expressed satisfaction with RST products and 76% have recommended Rosetta Stone to others.

Growth potential - RST feels their growth prospects going forward lie in the international markets. In 2008, just 5% of RST's revenues were derived outside the US.

Risk - 80% of RST's revenues are derived from US consumers. The big risk here would be a recession negatively impacting consumer discretionary spending coupled with a slowdown in international travel. We've certainly seen the first with consumer discretionary spending falling off a cliff in mid-September 2008. As RST is the first consumer discretionary ipo in quite awhile, this is a definite concern. Lets look at RST's 4th quarter of 2008 and see if revenues were impacted. In the 4th quarter of 2008, RST booked their best quarter in operating history in terms of revenues while maintaining gross margins and dropping sales and marketing expense in terms of percentage of revenues(a positive). Now seasonality plays a factor here as the 4th quarter annually has been RST's strongest due to holiday spending. RST however booked very solid revenue growth in the 4th quarter of 2008, much as they did a year prior in the 4th quarter of 2007. Quarter to quarter revenue growth in the 4th quarter of 2008 was a strong 11%, compared to 4th quarter of 2007 quarter to quarter revenue growth of 24%. Factoring in a near doubling of the revenue base in 2008 coupled with the difficult consumer spending environment in late 2008, the 4th quarter of 2008 for RST looks strong to me.

Returns - RST offers a 6 months 'no questions asked' money back guarantee on their products. In 2008 approximately 6% of all revenues were returned.

Competition - Berlitz International, Simon & Schuster, Inc. (Pimsleur), Random House,(Living Language), Disney Publishing Worldwide and McGraw-Hill Education. There is no pure public comparable to RST.

Risk – As mentioned, 80% of customer base in 2008 were individuals. As a result RST revenues could be affected by any trend changes in discretionary consumer spending and retail shopping patterns. Slowdown in international travel too carries a risk due to sales from airport kiosks forming almost a fifth of consumer driven revenues.


$2.67 in cash per share post-ipo, no debt.

Growth has been very strong in the past two years. As is often the case with software related ipos, gross margins are also impressive. Revenue growth was 50% in 2007 and actually increased in 2008 by 52% more. Rarely do you see a company deriving significant revenues ($209 million in 2008) and accelerating revenue growth year to year. That RST did so in a tough consumer 2008 environment is very impressive. The revenue growth here the past two years with back to back 50%+ growth is easily reason enough to recommend this ipo.

Seasonality - RST's best quarter tends to be the 4th quarter annually as they derive holiday related revenues.

RST's first profitable year was 2007.

2008 - Revenues were $209.3 million, a 52% increase over 2008. Gross margins were fat at 86%. As one would expect, sales and marketing expenses make up the bulk of RST's operating expenses. While in 2008 sales & marketing expense ratio was 45%, it did mark a decrease from 2007's 48% and 2006's 50%. Good sign, all things being equal you want to see sales and marketing expenses growing slower than actual revenues, allowing a company to filter more of those revenues to the bottom line. Operating expense ratio is also decreasing annually, exactly what one wants to see. Fast growing revenues and declining operating expense ratios are the ingredients of a top notch ipo. Operating expense ratio in 2008 was 72%, compared to 79% in 2007 and 80% in 2006. This number is still quite high in 2008, however the trends are improving and if RST can continue at this pace over the next 2-3 years, they will become a very profitable operation.

2008 operating margins were 14%. Plugging in anticipated post-ipo tax rate of 37%, net margins were 9%. Earnings per share were $0.91. On a pricing of $16, RST would trade at 17-18 X's trailing earnings with a 50% trailing revenue growth.

2009 - I just do not feel comfortable forecasting another 50%+ jump in annual revenue for 2009. Having written that, RST is poised to have a very strong 2009. In what was a difficult environment in 2008 with consumer discretionary spending falling precipitously overall, RST shined. Looking at quarter to quarter revenue growth at the end of 2008 and factoring in seasonality with a much slow first half of the year for RST historically....I would project very conservatively that RST can grow revenues 20% in 2009 to approximately $250 million. Gross margins should remain strong and I would project operating expense ratios to continue to decline, increasing operating and net margins. On a $250 million run rate, with 86% gross margins, 16% operating margins and 10% net margins, RST would earn $1.23 in 2009. On a pricing of $16, RST would trade 13 X's 2009 earnings.


How has RST thus far managed to sidestep a massive consumer spending slowdown? 22% of RST buyers responded in a survey they did so based on the personal recommendation of another. That is pretty powerful word of mouth marketing when annual revenue tops $200 million. Digging into this ipo, the one constant appears to be customer satisfaction driving growth. You really could not ask for much more with a consumer based ipo. RST looks poised to grow strongly in 2009 and is trending well in every facet of their business. If RST is able to build on their United States success globally over the next few years, this could be a huge long term winner coming public at just a $325 million market cap (based on a $16 pricing).

RST is a unique, and difficult to value sector leader with fast growing revenues, strong gross margins and improving operating expense ratios. All this equals a top-notch ipo. If RST can continue current trends for even another 2-3 quarters, the range of $15-$17 here is far too low. This is a strong recommend in range and one to pay up for if need be. The CEO describes his company as a 'disruptive value proposition' in language learning. I agree

April 2, 2009, 7:36 am

CYOU - Changyou.com

CYOU - Changyou.com

CYOU - Changyou.com plans on offering 7.5 million ADS at a range of $14-$16. Note that 1/2 the ADS in this offering will be sold by parent company Sohu.com (SOHU). Credit Suisse and Merrill Lynch are leading the deal, Citi and Susquehanna Financial are co-managing. Post-ipo CYOU will have 51.25 million ADS equivalent shares outstanding for a market cap of $769 million on a pricing of $15. Ipo proceeds will be utilized for general corporate purposes.

SOHU will own 71% of CYOU post-ipo. CYOU's CEO Tao Wang will own 15% of CYOU post-ipo. Note that post-ipo CYOU will be paying SOHU a one-time dividend of $96 million.

SOHU - A Chinese internet portal operating since 1998. Sohu has a current market cap of $1.56 billion and currently has over 250 million registered accounts.

From the prospectus:

"We are a leading online game developer and operator in China as measured by the popularity of our game Tian Long Ba Bu, or TLBB. TLBB, which was launched in May 2007, was ranked by International Data Corporation, or IDC, for 2007 as the third most popular online game overall in China and the second most popular online game in China among locally-developed online games."

On-line multi-player role playing game company, this CYOU ipo is similar in that fashion to this decade’s ipos of SNDA/NCTY/PWRD/GA. Below we'll do a comparison of those four with CYOU.

Tian Long Ba Bu(TLBB) was developed and launched in house at CYOU, then a part of SOHU. In addition to TLBB, CYOO also has licensed and operated Blade Online (BO). For the three months ending 12/31/08, TLBB had 1.8 million active paying accounts and BO had 159,000 active paying accounts.

Tian Long Ba Bu - 2.5D martial arts game was launched in May of 2007. Multi-player means literally over a million players/characters can inhabit the game playing universe at the same time. In 3/09, peak concurrent users exceeded 800,000. CYOU has also licensed this game to third party operators who run the game in Taiwan, Hong Kong, Vietnam, Malaysia and Singapore. Game players may play for free, however they must purchase pre-paid game cards to buy virtual items such as gems, pets, fashion items, magic medicine, riding animals, hierograms, skill books and fireworks. As is customary in China, pre-paid game cards are sold through regional third party distributors who then distribute to Internet cafes and various websites, newsstands, software stores, book stores and retail stores.

Pipeline - CYOU has three games in various stages of development: Duke of Mount Deer, or DMD, Immortal Faith, or IF, and the Legend of the Ancient World, or LAW. Duke of Mount Deer is another martial arts game and is being developed in-house. The other two will be licensed properties. Rollout of DMD will be 4th quarter of 2009 with the other two coming in 2009 and 2010 respectively. It would appear CYOU is banking on Duke of Mount Deer to be their next hit and hoping that this release will pick up the slack from the eventual player slowdown in TLBB.

Market segment - China's online game players numbered an estimated 40 million in 2007 with revenues of $1.4 billion. Online game revenues are expected to continue to grow to $3.4 billion in 2012 at a compound annual growth rate, or CAGR, of 19.9%.

Growth - 94% of CYOU's revenues in 2008 were from the game Tian Long Ba Bu(TLBB). Launched less than two years ago, TLBB has been a huge success generating over $180 million in revenues in 2008 alone. This ipo is based completely on the success of this one game. While TLBB has generated massive revenues and profitability, online video games tend to have a distinct lifespan and popularity curve. TLBB's popularity seems to have peaked in late 2008, so future growth is going to depend on CYOU's pipeline of coming games. TLBB in the 12/08 quarter had 1,822 paying accounts which was down slightly from the 9/08 quarter. Quarterly revenue growth from TLBB has gone from stratospheric to somewhat flat. Beginning with the 12/07 quarter, following is the quarter to quarter revenue growth of TLBB: 12/07 +102%; 3/08 +76%; 6/08 +13%; 9/08 +11%; 12/08 +6%. Looking at the slowing growth from TLBB, we can clearly see that CYOU will have difficulty growing going forward without their 4th quarter 2009 launch of Duke of Mount Deer becoming a big hit. In fact I would expect TLBB to book negative revenue growth quarter to quarter by the end of 2009 just as their next in-house game is launched.

Risk - the obvious risk here is a significant market cap on ipo of $769 million (assuming a $15 pricing) is based on one on-line game. Looking at the above slowing quarter to quarter growth trends of this one game and the risk here is that unless CYOU's next in-house game (due to hit in late 2009) is a big hit, revenues and earnings power will decline significantly as TLBB sees its popularity wane. This is a significant risk, especially as their new in-house game has yet to have a track record. For me, this large a market cap based on one game carries enough risk that I can only be, at best, neutral on this deal in range as the popularity of TLBB is already baked into the market cap in range.


After paying SOHU a $96 million dividend, CYOU will have slightly under $2 per share in cash post-ipo with no debt.

Revenue growth has been swift since the release of the Tian Long Ba Bu game. Revenues in 2006 were $8.5 million, in 2007 $42 million and in 2008 $201.8 million.

2008 - Revenues were $201.8 million, a massive increase over 2007. Tian Long Ba Bu accounted for 94% of those revenues. Gross margins were an impressive 93%. Operating expense ratio was 36%. Operating profits were 57%. In 2008 Tian Long Ba Bu was a money making machine. Normalizing CYOU's tax rate as it will appear post-ipo, net margins were 50%. Earnings per share were $1.97. On a pricing of $15, CYOU would trade 7-8 X's trailing earnings.

2009 - As noted above, quarter to quarter growth will slow dramatically from 2007 and 2008. CYOU's money making game TLBB appears as if it has peaked in popularity, or at least should see much more constrained revenue growth. As CYOU's next in-house developed game will not hit until late 2009, CYOU's revenues should be rather stagnant on a quarter to quarter basis throughout 2009. Projected revenues for 2009 should be in the $230 million ballpark, an increase of 15% over 2008. Much of this growth will be due to favorable comparables in the 3/09 quarter compared to 3/08 period. Gross margins look to continue to be 90%+. Operating expense ratios should be slightly higher as CYOU ramps up product development and sales/marketing efforts to promote new games. Lets plug in a 37% operating expense ratio. Operating margins should be 55%. It appears that for 2009-2011, CYOU will have an approximate tax rate of 12.5%. Net margins then should be approximately 42.5%. Earnings per share should be approximately $2 per share. On a pricing of $15, CYOU would trade 7 1/2 X's 2009 earnings.

Lets take a glance at CYOU's public competitors.

SNDA - $2.6 billion market cap. Currently trading 13 X's '09 estimates with an anticipated revenue growth of 25%.

NCTY - $370 million market cap. Currently trading 9 X's '09 estimates with an anticipated revenue growth of 9%.

PWRD - $789 million market cap. Currently trading 7 X's '09 estimates with an anticipated revenue growth of 22%.

GA - $1.6 billion market cap. Currently trading 12 X's '09 estimates with an anticipated revenue growth of 5%

Stacking CYOU up with these four, it does appear to be priced within the valuations of the above. A positive for CYOU is that they do have an extremely popular game. The downside is that nearly all revenues are derived from this one game and, at this point, we do not know whether CYOU will be successful in diversifying their game base and revenue stream.


On a trailing basis the CYOU ipo looks dirt cheap. The problem however is the ipo and market cap are based on the huge success of their game TLBB. It appears to me that TLBB has, at the very least, come close to peaking by late 2008. With their next in house game not launching until late 2009, I would project CYOU to see pretty flat revenues for '09 actually. Looking forward this is a pretty hefty market cap for reliance on one single game which saw its best year in 2008 and should decline somewhat in popularity going forward. The valuation is not out of line however and if CYOU's next in house game is another big it, there is potential for share price appreciation. Problem however is currently we have no idea how CYOU's future games will be received. We do know that the current success of TLBB is most definitely in the market cap on ipo. Neutral here in range. Swift growth in '08 and reasonable PE ratio is appealing, the lack of revenue diversification however is a pretty big sticking point for me.

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