Rosetta Stone (RST ) is a company that we have great respect for. In fact, we use the products ourselves. However, despite a recent run up in the stock, we are cautious on the name given performance. The company is a literacy education and language teaching operation. Products are used globally. The company’s language division uses cloud-based solutions to help all types of learners read, write, and speak more than 30 languages. Lexia Learning, Rosetta Stone's literacy education division, is the flagship operation. Hope for growing revenues in 2018 have helped drive the stock, but earnings remain a concern. In this column, we will discuss the performance of the name, honing in on segment specific performance, while offering our take here.

Sales in Q4

The company actually saw a rather weak Q4 sales wise, even if much of this weakness was anticipated.Total revenue was down 13% year-over-year to $44.8 million, reflecting a decline of $10.2 million or 84% in product revenue, which was only partially offset by an increase of $3.3 million or 8% in subscription and service revenue.

The decline in product revenue was attributable to the ongoing SaaS migration in Consumer Language.The increase in subscription and service revenue reflects continuing double-digit growth at Lexia and increases in the number of new subscribers and total subscribers in Consumer Language. 

Segment specific performance tells an interesting story

Lexia is the flagship operation for Rosetta Stone. Revenue at Lexia increased 23% year-over-year to $12.0 million in the fourth quarter 2017. Lexia's pro forma growth rate was 17% year-over-year. Lexia's sustained revenue growth reflects strong demand for its Core5 literacy curriculum product, high retention rates, and increased effectiveness its direct sales force initiatives.

There was weakness in the other two segments of the company. The Enterprise & Education Language segment revenue decreased 16% year-over-year to $15.0 million in the fourth quarter 2017. The decline included Rosetta’s decision to exit a direct sales and marketing presence in several countries, including China, Brazil and France, as part of the 2016 restructuring plan. In addition, a large multi-year sale in the fourth quarter 2016 was not eligible for renewal in the current quarter.

Even weaker was the Consumer Language segment. Here revenue declined 26% year-over-year to $17.8 million in the fourth quarter 2017, primarily reflecting the strategic shift. While this reflected an ongoing shift in the approach of the segment and transition to new standards, the number of paying Consumer Language subscribers in the fourth quarter 2017 increased 16% year-over-year to approximately 370,000 at December 31, 2017. This was strong.

Expenses

Thankfully, with revenues falling, total operating expenses decreased in tandem. They came in at $6.7 million or 15% year-over-year to $38.8 million in the fourth quarter 2017, reflecting the12th consecutive quarter of year-over-year expense reductions.

Excluding the $1.6 million in lease termination costs included in the fourth quarter 2016, total selling, administrative and research expenses decreased $5.1 million or 12% year-over-year, reflecting reductions of $2.8 million or 10% in sales and marketing expense, $1.2 million or 13% in general and administrative expense, and $1.0 million or 15% in research and development expense.

We should also add that lower media spend contributed to a $3.0 million year-over-year reduction in advertising costs in the fourth quarter. However, the impact to revenues was felt as well.

Earnings grew but tax reform played a large role

Net income improved year-over-year to $2.4 million or $0.10 per share in Q4, compared to a net loss of $5.6 million or $(0.25) per share last year. While this seems great, it is important to realize that this included a one-time, non-cash $5.5 million tax benefit associated with the Tax Cuts and Jobs Act and the fourth quarter 2016 net loss included lease termination costs totaling $1.6 million. What about for the entire year?

For the entire year 2017, net loss totaled $1.5 million, an improvement of $26.0 million or 94% compared to the net loss of $27.6 million in 2016. Loss per share was  $(0.07) in 2017, an improvement of $1.18 or 94% compared to $(1.25) per share in 2016.

Our take

We love the company, but its performance is subpar. We have substantial concerns over losses on the year, and know that Q4 earnings were driven entirely by tax reform issues. Cash concerns us as well.  The company had cash and cash equivalents of $43.0 million and zero debt at December 31, 2017. Deferred revenue totaled $151.3 million at December 31, 2017, compared to $141.5 million at December 31, 2016. Looking ahead, the company needs to focus on new subscribers, perhaps through varying tiers, and ultimately customer retention. The market for their products is wide and large, but thus far, it has not delivered. We would avoid the stock here.