ROSETTA STONE: pricing the 2009 IPOTeaching NoteThis 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 Questions1. 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 MaterialAlthough 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=3sViTF2AgxUVideo 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=jPx3dNmoyR8Video 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=1rdx2n3zNVcTeaching Plan1. What is going on at Rosetta Stone?The opening question is designed to allow students to put up the relevant background of the important managerial decisions facing Rosetta Stone management. In particular, the discussion should focus on the decision to go public and the price at which Rosetta Stone shares should be sold.2. Tell me about the economics of the Rosetta Stone business. Is this a business that you expect will generate interest among investors?This question invites students to explore the Rosetta Stone business model, its competitive strengths, and its potential to sustain a strong growth and profitability trajectory. Case Exhibit 6 can be a useful exhibit in highlighting the financial performance of the business. Typically students agree that Rosetta Stone is a very interesting business with strong potential for investors to participate in attractive financial upside potential.3. What do you think the current market price is for Rosetta Stone shares?Poll the class for their best-guess estimates of the market price of Rosetta Stone shares. Ask for an explanation for the variation in estimates. Draw out the observation that there is a substantial amount of uncertainty with valuing start-up businesses. The variation in class estimates is likely due to differences in judgment across thefd class as well as some possible technical errors in the valuations. Emphasize that, although there are no doubt many sound estimates, there are also substantial opportunities for error. An important objective of the discussion is to identify the sources of variation. Briefly review on the board the different parameters used by representative students in a discounted cash flow-based and a market multiples-based valuation.4. The market-multiples approach seems easy. What are the pros and cons of using a market-multiples approach in valuation?Have one of the students highlight the mechanics of a multiples-based valuation. For example, a simple valuation using K12, Inc. as a comparable would be as follows:Rosetta Stone EBITDA 2008 [case Exh. 7] | $ 34.6 million |K12 Inc. EV/EBITDA ratio 2008 [case Exh. 10] | 13.4 times |Implied Rosetta Stone enterprise value | $463.6 million |(34.6x13.4)Current Rosetta Stone debt [case Exh. 7] | $9.9 million |Implied equity value | $453.7 million |(Equity-Debt)Prior to offering shares outstanding [case Exh. 9] | 17.2 million |Implied share price | $ 26.38/share | (453.7/17.2)The instructor may elicit a discussion of the pros and cons of the market-multiples approach to valuation. The class may raise the following points:Pros of multiples* Convenient and simple* Reflects what the market is willing to pay for a comparable firm* Helpful when firm is not in steady state and future uncertainCons of multiples* Ignores need to make explicit assumptions regarding long-term profitability and growth* Subject to market misevaluation; a relative (rather than absolute) valuation measure* Subject to accounting distortions* May have difficulty in identifying comparable firms* Meaningless if financial numbers (e.g., EBITDA) are negative* Financial numbers in denominator may be more cyclical than valuation in numeratorThe 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.Although a multiples-based valuation approach provides a convenient, market-based approach for valuing businesses, there are several reasons to proceed with caution. The simplicity of multiples can be deceptive. Multiples should provide an alternative way to triangulate toward an appropriate long-term growth rate, not a way to avoid thinking about the long-term economics of a business. Market multiples are subject to distortions due to market misvaluations and accounting policy. Accounting numbers farther down in the income statement (like net earnings) are subject to greater distortion than items higher up in the income statement. Because market valuations tend to be less affected by business cycles than are annual profit figures, multiples can exhibit some business-cycle effects. Negative multiples based on negative profits are difficult to use. Last, identifying suitable comparable firms is essential but challenging.Multiples can be computed with different timing conventions. A trailing EBIT multiple for December 2001, for example, uses the December 2001 firm value divided by the 2001 EBIT. In contrast, a leading 2001 EBIT multiple is computed as the December 2001 firm value divided by the expected 2002 EBIT. Leading and trailing multiples can also be computed using figures from the next or most recent quarters. Leading and lagged multiples will be systematically different for growing businesses. When using multiples for valuation purposes, it is important to be consistent. If a trailing multiple is used, the end of Year 9 terminal value must be computed using the Year 9 financial forecast; if a leading multiple is used, the end of Year 9 terminal value must be computed using the Year 10 financial forecast.5. Lets look at a discounted cash flow-model approach to valuing Rosetta Stone. Is everyone comfortable with the financial forecast in case Exhibit 7? What are the key assumptions? Is the length of the forecast period reasonable?The case Exhibit 8 forecast is based on the following important assumptions:1. Revenue growth declining from 53% in 2008 to 5% in 2018.2. EBIT margin declining from 14% in 2008 to 7.5% in 2018, including a large R&D expense rate to maintain innovation in the business.3. An overall proportional increase in asset investment with revenue increases.The revenue projection typically generates the most discussion. Some students will argue that 20% to 35% growth rates are unreasonable (as suggested by some analysts); other students will make the case that Rosetta Stone has a demonstrated track record of growth and maintains large capacity for global expansion.One important concern that should be raised is the length of the planning period. Ten years may be too short to fully develop the Rosetta Stone strategy to a steady-state level, where growth slows to that of the general economy and economic profits are normal.6. What discount rate is appropriate for the cash-flow forecast?Because Rosetta Stone is not yet public, estimates for a market-based discount rate must be based on the expected returns associated with investments of similar risk. In calculating a discount rate, some parameters are straightforward. (The risk free rates are available in case Exhibit 4.) The cost of debt and marginal tax rate are mentioned in the case as 7.5% and 38%, respectively. The market risk premium is detailed in the case as 6.5% over long-term government yields or 8.5% over short-term government yields. Based on the industry comparables, leverage is lightly used among peer companies. The cost of debt should play a minor role in a weighted average cost of capital calculation. (CAPM beta estimates are available in case Exhibit 9.) However, the students face a challenge in identifying an appropriate set of comparable firms. A discussion can ensue regarding the nature of Rosetta Stone risk and how investors might consider matching on risk profile. Depending on the comparables chosen, reasonable discount rate estimates may vary from 7% to 13%. In the base case valuation used in this note, we use 10% as the discount rate.7. What was your approach for terminal value? How do your terminal value assumptions affect the estimated value of Rosetta Stone shares?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.It is worth emphasizing that the valuation of unseasoned equity is usually highly uncertain. The Rosetta Stone case provides a platform to illustrate this uncertainty. In order to appreciate the riskiness of any IPO valuation, one must recognize the magnitude of the uncertainty in the business forecasts. The companion Darden case JetBlue Airways IPO Valuation (UVA-F-1415) provides a context for illustrating this point with an arguably even larger amount of uncertainty.8. What is an IPO and why is it such a big deal? Is this a good idea for Rosetta Stone?This question is designed to briefly review any institutional questions students have on the IPO process. Exhibit TN2 provides a summary adapted from the one in the case of the timeline for a typical U.S. IPO.The instructor may solicit a critical evaluation of the costs and benefits of public offerings and then tease out the relative importance of such arguments to Rosetta Stone management. At the time, Rosetta Stone management claimed that the IPO was impelled by a need for capital to sustain its aggressive growth plans, by an interest in motivating employees, and by a desire to assist its private-equity investors in offsetting the large losses they were sustaining in their portfolios during this period of economic contraction. Generic benefits and costs of going public might include the following:Potential benefits* Improves access to capital market* Increases liquidity of entrepreneur/private investor wealth* Generates positive employee-compensation incentives* Builds firm credibility with customers and employees* Exposes management to public scrutiny (encourages value creation)Potential costs* Consumes company resources* Reveals information to competitors* Exposes management to public scrutiny (forces management to emphasize short-run over long-run performance)9. What offer price would you set for the Rosetta Stone IPO?This question invites a wrap-up of the case by discussing the strategy for pricing an IPO. Using a student-based estimate of the market value of a share of Rosetta Stone stock, the instructor can invite students to share their perspective on whether the stock should be priced above or below the market value. By setting the price above the market value, Rosetta Stone increases the potential proceeds from the offering but decreases the likelihood that investors will fully buy the deal, have a good experience with their investment, and not sue management. This discussion provides a good platform for examining the IPO underpricing puzzle. Exhibit TN2 provides a handout that includes some of the leading explanations of why firms tend to underprice their public shares.EpilogueLate Wednesday, April 15, 2009, management set the price at $18 per share, a dollar above its expected price range. The offer price was at 9 times EBITDA. Morgan Stanley and the syndicate of underwriters immediately contacted the investors in their book to begin selling the 3.125 million new shares and the 3.125 million private equity holder shares. The underwriters kept $1.26 for each share sold as a commission for a total fee of $7.9 million. The total offering netted $52.3 million for Rosetta Stone and $52.3 million for the private equity investors. Bridgepoint Education went public at the same time, but a poor showing on the road forced management to substantially lower the offer price from the filing range to just under 8 times EBITDA.The next day the Rosetta Stone team gathered on the podium at the New York Stock Exchange and rang the opening bell. The opening trade for Rosetta Stone stock (ticker symbol RST) was at $25, 39% above the offer price. The total equity market capitalization for Rosetta Stone was valued at 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 mid-August 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 TN1ROSETTA STONE: pricing the 2009 IPOCompany ValuationExhibit TN2ROSETTA STONE: pricing the 2009 IPOLife Cycle of a Typical U.S. IPO TransactionEvent 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.45 Registration (announcement) date. Firm files registration statement with SEC; registration statement is immediately available to the public.4575 SEC review period. SEC auditor reviews for compliance with SEC regulations. Underwriter assembles syndicate and prepares road show.50 Distribute preliminary prospectus (red herring).6075 Road show. Underwriters and issuing firms management present offering to interested institutional investors and build book of purchase orders.7599 Letters of comment received from SEC; amendments filed with SEC.99 Effective date. Underwriter and firm price offering. SEC gives final approval of registration statement.100 Public offering date. Stock issued and begins trading.108 Settlement date. Underwriter distributes proceeds to issuing firm.After market Underwriter may support new equity by acting as market maker and distributing research literature on issuing firm.Exhibit TN3ROSETTA STONE: pricing the 2009 IPOEvidence on IPO UnderpricingWinners Curse. Uninformed investors demand rationed for good firms and not for poor firms owing to informed investors participation in good IPOs only. Underpricing gives uninformed investors normal return.1Evidence: In countries where share allocation is transparent (e.g., Singapore and Finland), investors receive more shares of overpriced offerings so that average profits are zero.2Monopsony. Small number of underwriters following any particular industry allow for potential monopsony profits.3Evidence: In support, the severe average underpricing of 1980 was wholly concentrated among a few regional underwriters within the petroleum industry.4 Against support, an underwriter that takes itself public tends to underprice itself.5Lawsuit Avoidance. To avoid litigation for misrepresenting stock to shareholders, firms/underwriters discount initial price.Evidence: In support, offerings prior to the Securities Act of 1933 (which holds companies responsible for misrepresentation) tend to be less underpriced than offerings after 1933.6However, firms that are sued following their IPO tend to be just as underpriced as firms that are not sued.7Exhibit TN3 (continued)Reputation. Firms better able to access capital markets in future if they leave a good taste in investorsmouths.8Evidence: Little empirical support has been found for a relationship between underpricing and subsequent offerings.9Censored Distribution. Underwriters correctly price, on average, but stock-stabilization efforts remove the left-hand side of nonstabilized, first-day distribution of returnsleading to average positive performance.Evidence: A disproportionate number of IPOs have first-day returns of zero. IPOs with first-day returns of zero tend to experience negative returns over the first month, suggesting that they are temporarily held above their true value.10Bandwagon. If investors pay attention to IPO demands on other investors, bandwagon effects can create excessive demand for some offerings.11Exhibit TN4ROSETTA STONE: pricing the 2009 IPOAfter-Market Share-Price Performance, 2009Data source: Yahoo! Finance.--------------------------------------------[ 1 ]. It may be worth demonstrating that cash flow multiples such as EBIT and EBITDA are economically related to the constant-growth model. For example, the constant growth model can be expressed as follows:.Rearranging this expression gives a free cash flow multiple expressed in a constant-growth model.This expression suggests that cash-flow multiples are increasing in the growth rate and decreasing in the WACC. In the following table, one can vary the WACC and growth rate to produce the implied multiple.| | | WACC | || | 8% | 10% | 12% || 0% | 12.5 | 10.0 | 8.3 |Growth | 2% | 16.7 | 12.5 | 10.0 || 4% | 25.0 | 16.7 | 12.5 || 6% | 50.0 | 25.0 | 16.7 |[ 2 ]. This supplement was prepared by Associate Professor Michael J. 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