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RST > SEC Filings for RST > Form 10-K on 3-Mar-2014All Recent SEC Filings

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Annual Report

Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction with our consolidated financial statements and notes thereto which appear elsewhere in this Annual Report on Form 10-K. Our actual results may differ materially from those currently anticipated and expressed in such forward-looking statements as a result of a number of factors, including those discussed under ("Risk Factors") and elsewhere in this Annual Report on Form 10-K. Overview
Rosetta Stone Inc. ("Rosetta Stone," "the Company," "we" or "us") is dedicated to changing the way the world learns. Our innovative, technology-driven language-learning solutions have been purchased by millions of individuals and used by thousands of schools, businesses, and government organizations around the world. Founded in 1992, Rosetta Stone pioneered the use of interactive software to accelerate language learning. Today we offer courses in 30 languages across a broad range of formats, including online subscriptions, digital downloads, mobile apps, and perpetual CD-Rom packages. Rosetta Stone has invested more in language learning and expanded beyond language learning and deeper into education-technology with its acquisitions of Livemocha Inc. ("Livemocha") and Lexia Learning Systems Inc, ("Lexia") in 2013 and Vivity Labs, Inc. ("Vivity""), and Tell Me More S.A. ("Tell Me More") in January 2014. We derive our revenues from sales to both individual consumers and organizations. Our global consumer distribution model comprises a mix of our call centers, websites, third party e-commerce websites such as Digital River and Apple iTunes, select retail resellers, such as, Barnes & Noble, Target, Best Buy, Books-a-Million, Staples, Costco, daily deal partners such as Groupon, home shopping networks such as GS Home Shopping in Korea and consignment distributors such as Speed Commerce and third-party resellers of Lexia solutions. Our Global Enterprise & Education distribution model is focused on targeted sales activity primarily through a direct sales force in five markets: K-12 schools; colleges and universities; federal government agencies; corporations; and not-for-profit organizations.
Rosetta Stone's management team has communicated a strategic business plan designed to guide the Company through 2015. The key areas of focus are:
1.leveraging the brand;
2.innovating the platform; and
3.expanding distribution. In pursuing these priorities, we plan to grow the business by continuing to invest in research and development of new products while focusing on maintaining costs and margins at appropriate levels. During 2012, we instituted a change in our chief operating decision maker ("CODM"), which led to a fourth quarter change to what our CODM uses to measure profitability and allocate resources. Accordingly, beginning with the fourth quarter of 2012, we have three operating segments, North America Consumer, Rest of World ("ROW") Consumer and Global Enterprise & Education. From the first quarter of 2011 through the third quarter of 2012, we had two operating segments, Consumer and Global Enterprise & Education. Prior to 2011 we operated as a single segment.

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We will discuss the profitability of each segment in terms of segment contribution. Segment contribution is the measure of profitability used by our CODM. Segment contribution includes segment revenue and expenses incurred directly by the segment, including material costs, service costs, customer care and coaching costs, sales and marketing expense and bad debt expense. North America Consumer segment contribution improved from 41% of segment revenue for the year ended December 31, 2012 to 42% of segment revenue for the year ended December 31, 2013. The improvement in North America Consumer segment contribution is due to an increase in revenue of $1.2 million; this achievement is consistent with the goal established by management at the onset of 2012 to stabilize the U.S. consumer market. ROW Consumer segment contribution improved $1.9 million from the year ended December 31, 2012 to the year ended December 31, 2013 driven by a reduction in sales and marketing expense of $5.9 million, primarily the result of kiosk closures. Global Enterprise & Education segment contribution decreased to $21.0 million or 35%, for the year ended December 31, 2013 as compared to $26.6 million, or 44%, for the year ended December 31, 2012 primarily due to an increase in sales and marketing expense related to the addition of sales staff to this group. As our enterprise and education sales team gains traction we anticipate an improvement in contribution margin.
For additional information regarding our segments, see Note 16 of Item 8, Financial Statements and Supplementary Data. For additional information regarding fluctuations in segment revenue, see Results of Operations, below. Prior periods are presented consistent with our current operating segments and definition of segment contribution.
Business Metrics
Management uses the following key business metrics to measure the success of sales of our Rosetta Stone language-learning solutions in our combined North America and ROW Consumer segments. Management does not review these metrics at a disaggregated segment level. In addition, management does not currently use any comparable metrics to measure success of our Global Enterprise & Education segment.
Product software units. A unit is a perpetual software license sold as either tangible packaged software or as an online download.

Average revenue per product software unit. Consumer revenues derived from product software units divided by the number of product software units sold in the same period. Revenue from product software includes product revenue associated with product licenses in addition to service revenues associated with short-term online subscriptions that are bundled with our V4 TOTALe offering. Approximately $25 to $49 in revenue per unit is derived from service revenues associated with this short-term online subscription.

Paid online learners. The number of paid, active learners derived from the sale of a primarily online offering as of the end of a specified period. Applicable online offerings include purchases of subscription-based licenses for Rosetta Stone TOTALe, ReFLEX subscriptions, and purchasers of our product software who subsequently purchase renewals of their short-term online services.

Average revenue per paid online learner. Service revenues derived from paid online learners for a specified period divided by the average number of paid online learners during the same period, adjusted to a monthly rate. The average number of paid online learners for a quarter is calculated as the average of the beginning and ending number of paid online learners for the specified period. The average number of paid online learners for a year-to-date period is calculated as the average of the average number of paid online learners for quarters included in the specified year-to-date period.

The following table sets forth these unit and online learner metrics for the years ended December 31, 2013, 2012 and 2011:

                                                          Year Ended December 31,
                                                    2013             2012            2011
                                                  (in thousands, except per unit amounts)
Product software revenue                      $      179,211     $   198,075     $   199,963
Paid online learner revenues*                         24,703          14,999           8,063
Total consumer revenues                       $      203,914     $   213,074     $   208,026
Product software units                               681,612         629,779         585,774
Total paid online learners*                           94,056          68,393          26,567
Average revenue per product software unit     $          263     $       315     $       341
Average revenue per online learner*           $           25     $        26     $        35

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* Excludes revenue and learners from Livemocha operations and mobile applications.

Product software
Product software revenue includes sales of our Rosetta Stone Version 4 TOTALe product. We anticipate the mix of product units will shift from our traditional CD-ROM product to digital downloads in future periods. There is no difference in price between the two options.
Worldwide consumer revenue from product software decreased $18.9 million from the year ended December 31, 2012 to the year ended December 31, 2013, driven by a 17% decrease in the average revenue per unit, partially offset by a 8% increase in the number of units sold, compared to the prior year period. Worldwide consumer revenue from product software decreased $1.9 million from the year ended December 31, 2011 to the year ended December 31, 2012, driven by an 8% decrease in the average revenue per unit, partially offset by an 8% increase in the number of units sold, compared to the prior year period. Average revenue per product software unit has decreased as we have experimented with different price points and promotional offerings since the introduction of Version 4 TOTALe in 2010 including distribution partnerships within the daily deals market. The increase in product software units is due to our expansion into international markets and decreasing price points. Average Revenue Per Product Software Unit (ARPU)

Worldwide ARPU decreased $52, or 17%, from $315 for the year ended December 31, 2012 to $263 for the year ended December 31, 2013. The decline in ARPU is the result of multiple factors; 94% of the 17% reduction is associated with lower prices, which was driven by promotional pricing in North American Consumer, increased levels of daily deals at lower prices and increased price discounting in ROW Consumer. 6% of the 17% decrease in ARPU is due to our overall change in our sales channel mix. In the second quarter of 2013, we closed our entire U.S. kiosk sales channel. As a result, customers who would have purchased our products via kiosks made those purchases mainly in our 3rd party retail sales channel, which are sold to the retailers at lower prices. 79% of the decline in ARPU is attributable to declines in North America Consumer and 21% is due to declines in ROW Consumer. We are testing ways to stabilize prices and reduce discounting, however, in the near term we expect ARPU to continue to decline. Paid online learners
Revenue from paid online learners increased $9.7 million from the year ended December 31, 2012 to the year ended December 31, 2013, driven by a 38% increase in the number of paid online learners as of December 31, 2013, compared to the prior period. This increase was partially offset by a decrease in the average revenue per online learner due to the decrease in paid online subscription price points implemented in September 2013. Revenue from paid online learners increased $6.9 million from the year ended December 31, 2011 to the year ended December 31, 2012, driven by a 157% increase in the number of paid online learners as of December 31, 2012, compared to the prior period. This increase was partially offset by a decrease in the average revenue per online learner due to continued testing of online products at different price points. Bookings
In addition to the unit and learner metrics described above, management also uses bookings to evaluate the overall health of the business and evaluate performance. Bookings represent executed sales contracts received by the Company that are either recorded immediately as revenue or as deferred revenue. Management believes that bookings provides useful information to investors regarding certain financial and business trends relating to the Company's financial condition and results of operations. Components of Our Statement of Operations Revenue
We derive revenue from sales of language learning and reading solutions consisting of product software, audio practice products, professional services, and online software subscriptions. Revenue is presented as product revenue or subscription and service revenue in our consolidated financial statements. Our audio practice products are normally combined with our product software products and sold as a solution.
Our professional services include training, implementation services and dedicated conversational coaching associated with Rosetta Stone TOTALe. Rosetta Stone TOTALe online combines dedicated conversational coaching and an online software subscription. Rosetta Stone Version 4 TOTALe combines product software and dedicated conversational coaching. The content of our product software and subscription offerings are the same. We offer our customers the ability to choose which format they prefer without differentiating the learning experience. We bundle time-based subscription licenses of our web-based TOTALe

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services with perpetual licenses of our Rosetta Stone language learning solutions in the North America Consumer market. As a result, we typically defer 10%-35% of each of these bundled sales over the term of the subscription license.
We sell our solutions directly to individuals, educational institutions, corporations, and government agencies. We distribute our consumer products predominantly through our direct sales channels, primarily our websites and call centers, which we refer to as our direct-to-consumer channel. We also distribute our consumer products through select third-party retailers. The majority of our consumer customers purchase our product software and audio practice products, online software subscriptions and professional services. We sell to enterprise and education organizations primarily through our direct enterprise and education sales force as well as our network of resellers. Many organizations elect to license our products on a subscription basis. For purposes of explaining variances in our revenue, we separately discuss changes in our consumer and enterprise and education sales channels because the customers and revenue drivers of these channels are different.
Our consumer revenue is affected by seasonal trends associated with the holiday shopping season. As a result, our fourth quarter ended December 31, 2013 accounted for 29% of our annual revenue in 2013. Our enterprise and education revenue is seasonally stronger in the second and third quarters of the calendar year due to education and government purchasing cycles. We expect these trends to continue.
Cost of Product and Subscription and Service Revenue Cost of product revenue consists of the direct and indirect materials and labor costs to produce and distribute our products. Such costs include packaging materials, computer headsets, freight, inventory receiving, personnel costs associated with product assembly, third-party royalty fees and inventory storage, obsolescence and shrinkage. The cost of subscription and service revenue primarily represents costs associated with supporting our online language learning service, which includes online language conversation coaching, hosting costs and depreciation. We also include the cost of credit card processing and customer technical support in both cost of product revenue and cost of subscription and service revenue. We are also exploring additional measures to further address coaching costs including unbundling studio sessions from our product software offering.
Operating Expenses
We classify our operating expenses into three categories: sales and marketing, research and development and general and administrative.
Our operating expenses primarily consist of personnel costs, direct advertising and marketing expenses and professional fees associated with contract product development, legal, accounting and consulting. Personnel costs for each category of operating expenses include salaries, bonuses, stock-based compensation and employee benefit costs.
Sales and Marketing Our sales and marketing expenses consist primarily of direct advertising expenses related to television, print, radio, online and other direct marketing activities, personnel costs for our sales and marketing staff, rental payments for our kiosks (most of which were closed in the first half of 2013) and commissions earned by our sales personnel. Sales commissions are generally paid at the time the customer is invoiced. However, sales commissions are deferred and recognized as expense in proportion to when the related revenue is recognized. We intend to continue to expand our sales activities within some of our existing regions as well as to expand our presence into new countries, in addition to expanding our media and advertising campaigns in the U.S. We expect sales and marketing expenses to increase in future periods as we seek to stabilize and expand our operations in existing and new markets. Research and Development Research and development expenses consist primarily of personnel costs and contract development fees associated with the development of our solutions. Our development efforts are primarily based in the U.S. and are devoted to modifying and expanding our product portfolio through the addition of new content and new complementary products and services to our language learning and reading solutions. We expect our investment in research and development expenses to increase in future years as we deliver new products that will provide us with significant benefits in the future. In 2013 we restructured our product team, including the elimination of approximately seventy positions in our Harrisonburg, Virginia office and hiring personnel in Austin, Texas and San Francisco, California. We also acquired Livemocha and gained additional product personnel in Seattle, Washington. Payroll expenses have increased during 2013 due to hiring product team members in these more competitive labor markets. Rent has also increased due to our additional offices opened in 2013. General and Administrative General and administrative expenses consist primarily of personnel costs of our executive, finance, legal, human resources and other administrative personnel, as well as accounting and legal professional services fees including professional service fees related to acquisition and other corporate expenses. In 2013, there have been and we expect that there will continue to be increases to certain general and administrative expenses to support our due diligence efforts and integration of our recent acquisitions and continued expansion into international markets. However, we are also taking steps to reduce certain general and administrative expenses as we realign our cost structure to help fund investment in areas of growth.

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Interest and Other Income (Expense)
Interest and other income (expense) primarily consist of interest income, interest expense, foreign exchange gains and losses, and income from litigation settlements. Interest expense is primarily related to interest on our capital leases. Interest income represents interest received on our cash and cash equivalents. Fluctuations in foreign currency exchange rates in our foreign subsidiaries cause foreign exchange gains and losses. Legal settlements are related to agreed upon settlement payments from various anti-piracy enforcement efforts.
Income Tax Expense (Benefit)
Income tax expense (benefit) consists of federal, state and foreign income taxes. For the year ended December 31, 2013, our worldwide effective tax rate was approximately 10%. The income tax benefit in 2013 was primarily attributable to partial valuation releases related to the Livemocha and Lexia acquisitions offset by tax expense related to current year taxable income in Canada, Germany and the U.K., foreign withholding taxes, and the tax impact of amortization of indefinite-lived intangible assets.
We regularly evaluate the recoverability of our deferred tax assets and establish a valuation allowance, if necessary, to reduce the deferred tax assets to an amount that is more likely than not to be realized (a likelihood of more than 50 percent). Significant judgment is required to determine whether a valuation allowance is necessary and the amount of such valuation allowance, if appropriate.
In assessing the recoverability of our deferred tax assets, we consider all available evidence, including:
the nature, frequency, and severity of cumulative financial reporting losses in recent years;

the carryforward periods for the net operating loss, capital loss, and foreign tax credit carryforwards;

predictability of future operating profitability of the character necessary to realize the asset;

prudent and feasible tax planning strategies that would be implemented, if necessary, to protect against the loss of the deferred tax assets; and

the effect of reversing taxable temporary differences.

The evaluation of the recoverability of the deferred tax assets requires that we weigh all positive and negative evidence to reach a conclusion that it is more likely than not that all or some portion of the deferred tax assets will not be realized. The weight given to the evidence is commensurate with the extent to which it can be objectively verified. The more negative evidence that exists, the more positive evidence is necessary and the more difficult it is to support a conclusion that a valuation allowance is not needed.
As of December 31, 2012, we performed an analysis on the need for a valuation allowance on our deferred tax assets in various jurisdictions. Our analysis considered a number of factors, including our cumulative loss over the last three years, our expectation of future taxable income and the time frame over which our net operating losses expire. This analysis resulted in the need for valuation allowances in the U.S., Korea, Japan and Brazil. We have maintained a valuation allowance against our deferred tax assets in the U.S., Korea, Japan and Brazil through December 31, 2013. All four jurisdictions have cumulative losses and pre-tax losses for the most recent year ended December 31, 2013. The establishment of a valuation allowance has no effect on the ability to use the deferred tax assets in the future to reduce cash tax payments. We will continue to assess the likelihood that the deferred tax assets will be realizable at each reporting period, and the valuation allowance will be adjusted accordingly, which could materially affect our financial position and results of operations.
Critical Accounting Policies and Estimates In presenting our financial statements in conformity with accounting principles generally accepted in the U.S., we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures.
Some of the estimates and assumptions we are required to make relate to matters that are inherently uncertain as they pertain to future events. We base these estimates and assumptions on historical experience or on various other factors that we believe to be reasonable and appropriate under the circumstances. On an ongoing basis, we reconsider and evaluate our estimates and assumptions. Our future estimates may change if the underlying assumptions change. Actual results may differ significantly from these estimates.

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We believe that the critical accounting policies listed below involve our more significant judgments, assumptions and estimates and, therefore, could have the greatest potential impact on our consolidated financial statements. In addition, we believe that a discussion of these policies is necessary to understand and evaluate the consolidated financial statements contained in this annual report on Form 10-K.
Revenue Recognition
Our primary sources of revenue are online subscriptions, software and bundles of software and online subscriptions. We also generate revenue from the sale of audio practice products and training and implementation services. Revenue is recognized when all of the following criteria are met: there is persuasive evidence of an arrangement; the product has been delivered or services have been rendered; the fee is fixed or determinable; and collectability is reasonably assured. Revenues are recorded net of discounts.
We identify the units of accounting contained within our sales arrangements in accordance with ASC 605-25 Revenue Recognition - Multiple Element Arrangements ("ASC 605-25"). In doing so, we evaluate a variety of factors including whether the undelivered element(s) have value to our customer on a stand-alone basis or if the undelivered element(s) could be sold by another vendor on a stand-alone basis.
For multiple element arrangements that contain software products and related services, we allocate the total arrangement consideration to all deliverables based on vendor-specific objective evidence of fair value, or VSOE, in accordance with ASC subtopic 985-605-25 Software: Revenue Recognition-Multiple-Element Arrangements ("ASC 985-605-25"). We generate a substantial portion of our consumer revenue from Rosetta Stone Version 4 TOTALe which is a multi-element arrangement that includes perpetual software bundled with the subscription and conversational coaching components of our TOTALe online service. We have identified two deliverables generally contained in Rosetta Stone V4 TOTALe software arrangements. The first deliverable is the perpetual software, which is delivered at the time of sale, and the second deliverable is the subscription service. We allocate revenue between these two deliverables using the residual method based on the existence of VSOE of the subscription service. In the U.S., we offer consumers who purchase our packaged software and audio practice products directly from us a 30-day, unconditional, full money-back refund. We also permit some of our retailers and distributors to return packaged products, subject to certain limitations. We establish revenue reserves for packaged product returns based on historical experience, estimated channel inventory levels, the timing of new product introductions and other factors.
For non-software multiple element arrangements we allocate revenue to all deliverables based on their relative selling prices.
We distribute our products and services both directly to the end customer and indirectly through resellers. Our resellers earn commissions generally calculated as a fixed percentage of the gross sale to the end customer. We evaluate each of our reseller relationships in accordance with ASC 605-45 Revenue Recognition - Principal Agent Considerations ("ASC 605-45") to determine whether the revenue we recognize from indirect sales should be the gross amount of the contract with the end customer or reduced for the reseller commission. In making this determination we evaluate a variety of factors including whether we are the primary obligor to the end customer.
Revenue for online service subscriptions is recognized ratably over the term of the subscription period, assuming all revenue recognition criteria have been met. Rosetta Stone Version 4 TOTALe bundles, which include an online service subscription including conversational coaching and packaged software, allow customers to begin their online services at any point during a registration window, which is up to six months from the date of purchase from us or an authorized reseller. Online service subscriptions that are not activated during this registration window are forfeited and revenue is recognized upon expiry. Revenue from non-refundable upfront fees that are not related to products already delivered or services already performed is deferred and recognized over . . .

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