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Teaching Note
This case examines the April 2009 decision of Rosetta Stone management
to price the initial public offering of Rosetta Stone stock during one of the
most difficult periods in capital-raising history. The case outlines Rosetta
Stones unique language-learning strategy and its associated strong
financial performance. Students are invited to value the stock and take a
position on whether the current $15 to $17 per share filing range is
appropriate. The case is designed to showcase corporate valuation using
discounted cash flow and peer-company market multiples. The epilogue
details the 40% first-day rise in Rosetta Stone stock from the $18 offer
price. With this backdrop, students are exposed to a well-known finance
anomalythe IPO underpricing phenomenonand are invited to critically
discuss various proposed explanations.
The case provides opportunities for the instructor to develop any of the
following teaching objectives:
* Review the institutional aspects of the equity issuance transaction.
* Explore the costs and benefits associated with public share offerings.
* Develop an appreciation for the challenges of valuing unseasoned firms.
* Hone corporate valuation skills, particularly using market multiples.
* Evaluate the received explanations of various finance anomalies, such as
the IPO underpricing phenomenon.
Study Questions
1. What are the advantages and disadvantages of Rosetta Stone going
public?
2. What do you think the current market price is for Rosetta Stone shares?
Justify your valuation on a discounted-cash-flow basis and a market
multiples basis.
3. At what price would you recommend that Rosetta Stone shares be sold?
Supplementary Material
Although the context of the discussion is mergers, the Darden technical
note Methods of Valuation for Mergers and Acquisitions (UVA-F-1274)
reviews the mechanics of firm valuation using discounted cash flow and
comparable multiples. This teaching note may be assigned as reference
material for the valuation analysis required in this case.
Supplementary video in support of this case is available from the Darden
Publishing channel on YouTube by using the links provided in the case.
There are three video exhibits available for the instructors use:
Video Exhibit TN1. Epilogue 1 is a designed for use at the end of class as a
synopsis of the pricing decision or as an introduction to a discussion on the
IPO underpricing phenomenon. It features interviews with Tom Adams,
CEO, Rosetta Stone, Inc. and Phil Clough, Managing General Partner, ABS
Capital Partners.
http://www.youtube.com/watch?v=3sViTF2AgxU
Video Exhibit TN2. Epilogue 2 is a short clip of Tom Adams, CEO of
Rosetta Stone, discussing the industry classification of Rosetta Stone.
http://www.youtube.com/watch?v=jPx3dNmoyR8
Video Exhibit TN3. Epilogue 3 is a designed for use at the end of class to
summarize the stock price history for Rosetta Stones first year of trading.
http://www.youtube.com/watch?v=1rdx2n3zNVc
Teaching Plan
1. What is going on at Rosetta Stone?
The instructor may flesh out these points in greater detail. Some
perspective on important principles worthy of consideration by the financial
analyst is detailed below.
In sampling industry comparables, we want to include only those firm
valuations that are comparable to the business of interest. If the profits for a
comparable firm are expected to grow at a higher rate, the valuation or
capitalization of those profits will occur at a higher level because investors
anticipate higher future profits and consequently bid up the value of the
respective capital. There is much here to discuss in the case of Rosetta
Stone. One important debate surrounds whether the business is a software
business or an education business. The outcome of this decision maintains
large valuation effects.
One might consider other multiples of observable quantities for valuation
purposes. One common multiple is the earnings or P/E multiple. This
multiple compares the value of the equity with the value of the net income.
In a free cash flow-valuation model, earnings multiples are inappropriate for
use because they value only the equity portion and assume a certain
capital structure. The market-to-book ratio faces similar concerns. Common
multiples appropriate for free cash flow valuation include EBITDA (earnings
before interest, tax, depreciation, and amortization), EBIT, and total capital
multiples. In this case, we have a particular challenge with the P/E ratios:
The majority of the estimates are negative.
The instructor can explore the advantages and disadvantages of using
EBIT, EBITDA, or total capital ratios as terminal-value estimators. The
choice of multiple metric depends on the comparability of the value
relationships between firms used to provide the estimate and the valuation
firm. For example, EBITDA is more appropriate for capital-intensive firms,
where the depreciation-expense relationships differ between the valuation
firm and its peers. Although commonly used, the earnings (P/E) and book
equity (market-to-book) ratios may be inappropriate if the leverage differs
across comparable firms. These approaches are also inconsistent with free
cash flow-based terminal-value calculations. Lastly, the negative net
earnings common to this industry in 2001 create an additional challenge to
P/E-based valuation.
The instructor can emphasize that the terminal value estimate plays an
important role in a company valuation. The instructor can canvass the class
for techniques for estimating terminal value.
Exhibit TN1 illustrates a constant growth-model approach to terminal value
estimation. In this approach, we estimate a steady-state cash flow in 2019.
This cash flow assumes that the income statement and the balance sheet
grow at a steady-state growth rate of 4%. To do this, we grow the NOPAT,
net working capital, and net PPE lines at the steady-state growth rate. The
steady-state cash flow is equal to the 2019 NOPAT less the investment in
net working capital and net PPE. The 4% rate is set based on an
expectation of 2% real growth and 2% expected inflation (based on the
3.8% 30-year Treasury yield less an assumed real rate of interest of 1.8%).
The terminal value is estimated using the perpetuity formula, with the value
at time 0 equal to cash flow at time 1 divided by the difference in the
discount rate and the constant growth rate. The terminal value in 2018 is
estimated to be $972 million.
Given that EBITDA in 2018 is estimated to be $110 million (EBIT of $106.6
million plus depreciation of $3.4 million), the $972 million terminal value
implies an enterprise value-to-EBITDA ratio of 8.8 times. Such a multiple
seems reasonable when reconciled with the mature comparables in case
Exhibit 9. It is worth noting that only the mature industry comparables are
appropriate to benchmark Rosetta Stone in the steady-state year. Using the
market multiple of a rapidly growing business, such as that associated with
K12 Inc., would bias upward the terminal value.
The case explains that some analysts were skeptical of the magnitude of
the revenue growth forecasts in case Exhibit 7, claiming that revenue
growth is better justified at 15% over the near term and 3% to 4% over the
long term. The instructor can solicit threats to the projected revenue path
that include ongoing declines in economic conditions, increased
competition, and difficulties in expanding outside the United States such as
product, marketing, and intellectual property adjustments. Adjusting the
model to incorporate this reduction in revenue growth decreases the
implied share value from $31 in Exhibit TN1 to under $20. Given the
profitability of the business, revenue growth is an important value driver.
more than $500 million. That first day, 8.3 million shares traded at between
$24 and $26. The U.S. IPO market was back. Tom Adams and Phil Clough
were delighted with the buzz generated by the deal and the first-day pop in
returns.
The share-price performance over the remainder of the year is provided in
Exhibit TN3. Of particular note is the management announcement in midAugust that, due to rising operating costs, the quarterly and annual
earnings outlook would be substantially lower than anticipated. As part of
the announcement, Rosetta Stone canceled the follow-on offering of
another 4 million shares held by its private equity investors. The price of
Rosetta Stone stock plunged 26% with the announcement and failed to
recover during the remainder of the year.
In subsequent years, Rosetta Stone failed to live up to its IPO expectations,
as revenue growth was 21% for 2009 and just 3% in 2010. EBIT for 2010
came in at under $13 million.
Exhibit TN1
ROSETTA STONE: pricing the 2009 IPO
Company Valuation
Exhibit TN2
ROSETTA STONE: pricing the 2009 IPO
Life Cycle of a Typical U.S. IPO Transaction
Event time (in days) Event
< 0 Underwriter selection meeting.
0 Organizational all-hands meeting. Quiet period begins.
1544 Due diligence. Underwriter interviews management, suppliers, and
customers; reviews financial statements; drafts preliminary registration
statement. Senior management of underwriter gives OK on issue.
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