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EX-10.2 - EXHIBIT 10.2 - ROSETTA STONE INCa03312015exhibit102.htm
EX-10.3 - EXHIBIT 10.3 - ROSETTA STONE INCa03312015exhibit103.htm
EX-10.1 - EXHIBIT 10.1 - ROSETTA STONE INCa03312015exhibit101.htm
EX-31.2 - EXHIBIT 31.2 - ROSETTA STONE INCa03312015exhibit312.htm
EX-32.2 - EXHIBIT 32.2 - ROSETTA STONE INCa03312015exhibit322.htm
EX-32.1 - EXHIBIT 32.1 - ROSETTA STONE INCa03312015exhibit321.htm
EX-31.1 - EXHIBIT 31.1 - ROSETTA STONE INCa03312015exhibit311.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2015
Commission file number: 1-34283
Rosetta Stone Inc.
(Exact name of registrant as specified in its charter)
Delaware
(State of incorporation)
 
043837082
(I.R.S. Employer
Identification No.)
1919 North Lynn St., 7th Fl.
Arlington, Virginia
(Address of principal executive offices)
 
22209
(Zip Code)

703-387-5800
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes ý  No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ý  No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer o
 
Accelerated filer ý
 
Non-accelerated filer o
 
Smaller reporting company o
 
 
 
 
 (Do not check if a smaller reporting company)
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No ý
 
Indicate the number of shares outstanding of each of the issuer’s classes of stock, as of the latest practicable date.
As of April 30, 2015, there were 21,610,589 shares of the registrant’s Common Stock, $.00005 par value, outstanding.





ROSETTA STONE INC.

Table of Contents



2


PART I. FINANCIAL INFORMATION

Item 1.  Financial Statements
ROSETTA STONE INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)
(unaudited)
 
 
March 31,
2015
 
December 31,
2014
Assets
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
45,924

 
$
64,657

Restricted cash
 
106

 
123

Accounts receivable (net of allowance for doubtful accounts of $1,410 and $1,434, at March 31, 2015 and December 31, 2014, respectively)
 
50,909

 
76,757

Inventory, net
 
8,408

 
6,500

Deferred sales commissions
 
10,678

 
10,740

Prepaid expenses and other current assets
 
6,258

 
5,038

Income tax receivable
 
895

 
464

Total current assets
 
123,178

 
164,279

Deferred sales commissions
 
4,318

 
4,362

Property and equipment, net
 
25,019

 
25,277

Goodwill
 
56,402

 
58,584

Intangible assets, net
 
32,203

 
34,377

Other assets
 
1,787

 
1,525

Total assets
 
$
242,907

 
$
288,404

Liabilities and stockholders' equity
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable
 
$
15,071

 
$
19,548

Accrued compensation
 
12,981

 
14,470

Obligations under capital lease
 
361

 
594

Other current liabilities
 
44,914

 
56,157

Deferred revenue
 
88,589

 
95,240

Total current liabilities
 
161,916

 
186,009

Deferred revenue
 
31,634

 
32,929

Deferred income taxes
 
1,810

 
1,554

Obligations under capital lease
 
2,722

 
3,154

Other long-term liabilities
 
1,087

 
1,313

Total liabilities
 
199,169

 
224,959

Commitments and contingencies (Note 15)
 

 

Stockholders' equity:
 
 
 
 
Preferred stock, $0.001 par value; 10,000 and 10,000 shares authorized, zero and zero shares issued and outstanding at March 31, 2015 and December 31, 2014, respectively
 

 

Non-designated common stock, $0.00005 par value, 190,000 and 190,000 shares authorized, 23,268 and 22,936 shares issued and 22,268 and 21,936 shares outstanding at March 31, 2015 and December 31, 2014, respectively
 
2

 
2

Additional paid-in capital
 
179,878

 
178,554

Accumulated loss
 
(122,882
)
 
(102,998
)
Accumulated other comprehensive loss
 
(1,825
)
 
(678
)
Treasury stock, at cost, 1,000 and 1,000 shares at March 31, 2015 and December 31, 2014, respectively
 
(11,435
)
 
(11,435
)
Total stockholders' equity
 
43,738

 
63,445

Total liabilities and stockholders' equity
 
$
242,907

 
$
288,404

   
See accompanying notes to consolidated financial statements

3


ROSETTA STONE INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(Unaudited)

 
 
Three Months Ended 
 March 31,
 
 
2015
 
2014
Revenue:
 
 
 
 
Product
 
$
19,974

 
$
32,371

Subscription and service
 
38,468

 
28,394

Total revenue
 
58,442

 
60,765

Cost of revenue:
 
 
 
 
Cost of product revenue
 
5,637

 
7,824

Cost of subscription and service revenue
 
5,665

 
4,347

Total cost of revenue
 
11,302

 
12,171

Gross profit
 
47,140

 
48,594

Operating expenses:
 
 
 
 
Sales and marketing
 
40,150

 
39,096

Research and development
 
8,972

 
8,773

General and administrative
 
15,754

 
16,054

Impairment
 
291

 
2,199

Lease abandonment and termination
 

 
3,571

Total operating expenses
 
65,167

 
69,693

Loss from operations
 
(18,027
)
 
(21,099
)
Other income and (expense):
 
 
 
 
Interest income
 
4

 
5

Interest expense
 
(88
)
 
(56
)
Other income and (expense)
 
(1,581
)
 
226

Total other income and (expense)
 
(1,665
)
 
175

Loss before income taxes
 
(19,692
)
 
(20,924
)
Income tax expense (benefit)
 
192

 
(683
)
Net loss
 
$
(19,884
)
 
$
(20,241
)
Loss per share:
 
 
 
 
Basic
 
$
(0.95
)
 
$
(0.96
)
Diluted
 
$
(0.95
)
 
$
(0.96
)
Common shares and equivalents outstanding:
 
 
 
 
Basic weighted average shares
 
21,018

 
21,125

Diluted weighted average shares
 
21,018

 
21,125

   
See accompanying notes to consolidated financial statements

4


ROSETTA STONE INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(in thousands)
(Unaudited)


 
 
Three Months Ended 
 March 31,
 
 
2015
 
2014
Net loss
 
$
(19,884
)
 
$
(20,241
)
Other comprehensive loss, net of tax:
 
 
 
 
Foreign currency translation loss
 
(1,147
)
 
(364
)
Other comprehensive loss
 
(1,147
)
 
(364
)
Comprehensive loss
 
$
(21,031
)
 
$
(20,605
)
   See accompanying notes to consolidated financial statements




5


ROSETTA STONE INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
 
 
Three Months Ended 
 March 31,
 
 
2015
 
2014
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
 
Net loss
 
$
(19,884
)
 
$
(20,241
)
Adjustments to reconcile net loss to cash used in operating activities:
 
 
 
 
Stock-based compensation expense
 
1,287

 
1,406

Loss on foreign currency transactions
 
1,372

 

Bad debt expense
 
410

 
957

Depreciation and amortization
 
3,350

 
3,434

Deferred income tax expense (benefit)
 
295

 
(756
)
Loss (gain) on disposal of equipment
 
(1
)
 
106

Amortization of debt issuance costs
 
32

 

Loss on impairment
 
291

 
2,199

Net change in:
 
 
 
 
Restricted cash
 
17

 
60

Accounts receivable
 
24,546

 
17,916

Inventory
 
(1,957
)
 
(1,034
)
Deferred sales commissions
 
59

 
(1,377
)
Prepaid expenses and other current assets
 
(1,322
)
 
536

Income tax receivable
 
(444
)
 
(639
)
Other assets
 
(314
)
 
690

Accounts payable
 
(4,401
)
 
512

Accrued compensation
 
(1,146
)
 
(8,123
)
Other current liabilities
 
(9,041
)
 
(9,461
)
Other long-term liabilities
 
(225
)
 
(172
)
Deferred revenue
 
(6,231
)
 
358

Net cash used in operating activities
 
(13,307
)
 
(13,629
)
CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
 
Purchases of property and equipment
 
(2,382
)
 
(1,366
)
Decrease in restricted cash for Vivity acquisition
 

 
12,314

Acquisitions, net of cash acquired
 
(1,688
)
 
(40,161
)
Net cash used in investing activities
 
(4,070
)
 
(29,213
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
 
Proceeds from the exercise of stock options
 
37

 
454

Payment of financing fees
 
(27
)
 

Payments under capital lease obligations
 
(282
)
 
(61
)
Net cash (used in) provided by financing activities
 
(272
)
 
393

Decrease in cash and cash equivalents
 
(17,649
)
 
(42,449
)
Effect of exchange rate changes in cash and cash equivalents
 
(1,084
)
 
(402
)
Net decrease in cash and cash equivalents
 
(18,733
)
 
(42,851
)
Cash and cash equivalents—beginning of period
 
64,657

 
98,825

Cash and cash equivalents—end of period
 
$
45,924

 
$
55,974

SUPPLEMENTAL CASH FLOW DISCLOSURE:
 
 
 
 
Cash paid during the periods for:
 
 
 
 
Interest
 
$
57

 
$
56

Income taxes
 
$
463

 
$
820

Noncash financing and investing activities:
 
 
 
 
Accrued liability for purchase of property and equipment
 
$
732

 
$
353

See accompanying notes to consolidated financial statements



6


ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. NATURE OF OPERATIONS
Rosetta Stone Inc. and its subsidiaries ("Rosetta Stone," or the "Company") develop, market and support a suite of language-learning, literacy and brain fitness solutions consisting of perpetual software products, web-based software subscriptions, online and professional services, audio practice tools and mobile applications. The Company's offerings are sold on a direct basis and through third party resellers, distributors and select retailers. The Company provides its solutions to customers through the sale of packaged software and web-based software subscriptions, domestically and in certain international markets.
On March 11, 2015, the Company announced a plan (the "2015 Restructuring Plan") to accelerate and prioritize our focus on satisfying the needs of more serious Corporate and K-12 learners, and emphasizing those who need to speak and read English. In the first quarter of 2015, the Company began reductions to areas including consumer sales and marketing, consumer product investment, and general and administrative costs. See Note 2 "Summary of Significant Accounting Policies," Note 13 "Restructuring," Note 16 "Segment Information" and Item 2 "Management's Discussion and Analysis of Financial Condition and Results of Operations" within Part 1 for additional information about these strategic undertakings and the associated impact to the Company's financial statements and financial results.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of Rosetta Stone Inc. and its wholly owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. Certain amounts in the prior period consolidated financial statements have been reclassified to conform to the current period presentation. 
Basis of Presentation
The accompanying consolidated financial statements are unaudited. These unaudited interim consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and applicable rules and regulations of the Securities and Exchange Commission ("SEC") regarding interim financial reporting. Certain information and note disclosures normally included in the financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Accordingly, these interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s most recent Annual Report on Form 10-K filed with the SEC on March 16, 2015. The March 31, 2015 consolidated balance sheet included herein includes account balances as of December 31, 2014 that were derived from the audited financial statements as of that date. The Consolidated Financial Statements and the Notes to the Consolidated Financial Statements do not include all disclosures required for annual financial statements and notes.
The unaudited interim consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary for the fair presentation of the Company’s statement of financial position at March 31, 2015 and December 31, 2014, the Company’s results of operations for the three months ended March 31, 2015 and 2014 and its cash flows for the three months ended March 31, 2015 and 2014 have been made. The results for the three months ended March 31, 2015 are not necessarily indicative of the results to be expected for the year ending December 31, 2015. All references to March 31, 2015 or to the three months ended March 31, 2015 and 2014 in the notes to the consolidated financial statements are unaudited.
Use of Estimates
The preparation of financial statements in accordance with GAAP requires that management make certain estimates and assumptions. Significant estimates and assumptions have been made regarding the allowance for doubtful accounts, estimated sales returns, stock-based compensation, restructuring costs, fair value of intangibles and goodwill, inventory reserve, sales reserves, disclosure of contingent assets and liabilities, disclosure of contingent litigation, and allowance for valuation of deferred tax assets. Actual results may differ from these estimates.

7

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Revenue Recognition
The Company's primary sources of revenue are web-based software subscriptions, online services, perpetual product software, and bundles of perpetual product software and short-term online services. The Company also generates revenue from the sale of audio practice products, mobile applications, and professional 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. Revenue is recorded net of discounts.
The Company identifies the units of accounting contained within sales arrangements in accordance with Accounting Standards Codification ("ASC") subtopic 605-25, Revenue Recognition - Multiple Element Arrangements (“ASC 605-25”). In doing so, the Company evaluates a variety of factors including whether the undelivered element(s) have value to the 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 perpetual software products and related services, the Company allocates the total arrangement consideration to its deliverables based on vendor-specific objective evidence of fair value, or vendor-specific objective evidence ("VSOE"), in accordance with ASC subtopic 985-605-25, Software: Revenue Recognition-Multiple-Element Arrangements ("ASC 985-605-25"). The Company generates a substantial portion of its consumer revenue from the CD and digital download formats of the Rosetta Stone language-learning product which is typically a multiple-element arrangement that includes two deliverables: the perpetual software, delivered at the time of sale, and the short-term online service, which is considered a software-related element. The online service includes short-term access to conversational coaching services. Because the Company only sells perpetual language-learning software on a stand-alone basis in its homeschool version, the Company does not have a sufficient concentration of stand-alone sales to establish VSOE for this element. Accordingly, the Company allocates the arrangement consideration using the residual method based on the existence of VSOE of the undelivered element, the short-term online service. The Company determines VSOE of the short-term online service by reference to the range of stand-alone renewal sales of the three-month online service. The Company reviews these stand-alone sales on a quarterly basis. VSOE is established if at least 80% of the stand-alone sales are within a range of plus or minus 15% of a midpoint of the range of prices, consistent with generally accepted industry practice.
For non-software multiple element arrangements the Company allocates revenue to all deliverables based on their relative selling prices. The Company's non-software multiple element arrangements primarily occur as sales to its Enterprise & Education customers. These arrangements can include web-based subscription services, audio practice materials and professional services or any combination thereof. The Company does not have a sufficient concentration of stand-alone sales of the various deliverables noted above to its Enterprise & Education customers, and therefore cannot establish VSOE for each deliverable. Third party evidence of fair value does not exist for the web-based subscription, audio practice and professional services due to the lack of interchangeable language-learning products and services within the market. Accordingly, the Company determines the relative selling price of the web-based subscription, audio practice tools and professional services deliverables included in its non-software multiple-element arrangements using the best estimated selling price. The Company determines the best estimated selling price based on its internally published price list which includes suggested sales prices for each deliverable based on the type of client and volume purchased. This price list is derived from past experience and from the expectation of obtaining a reasonable margin based on what each deliverable costs the Company.
In the U.S. and Canada, the Company offers consumers who purchase packaged software and audio practice products directly from the Company a 30-day, unconditional, full money-back refund. The Company also permits some of our retailers and distributors to return unsold packaged products, subject to certain limitations. In accordance with ASC subtopic 985-605, Software: Revenue Recognition ("ASC 985-605"), the Company estimates and establishes revenue reserves for packaged product returns at the time of sale based on historical return rates, estimated channel inventory levels, the timing of new product introductions and other factors.
The Company distributes its products and services both directly to the end customer and indirectly through resellers. Resellers earn commissions generally calculated as a fixed percentage of the gross sale to the end customer. The Company evaluates each of its reseller relationships in accordance with ASC subtopic 605-45, Revenue Recognition - Principal Agent Considerations (“ASC 605-45”) to determine whether the revenue recognized 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 the Company evaluates a variety of factors including whether it is the primary obligor to the end customer. Revenue is recorded net of taxes.
Revenue for online services and web-based subscriptions is recognized ratably over the term of the service or subscription period, assuming all revenue recognition criteria have been met. The CD and digital download formats of Rosetta Stone language-learning products are bundled with a short-term online service where customers are allowed to begin their

8

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

short-term 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. The short-term online services 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 the term of the related arrangement because the period over which a customer is expected to benefit from the service that is included within our subscription arrangements does not extend beyond the contractual period. Accounts receivable and deferred revenue are recorded at the time a customer enters into a binding subscription agreement.
Software products include sales to end user customers and resellers. In many cases, revenue from sales to resellers is not contingent upon resale of the software to the end user and is recorded in the same manner as all other product sales. Revenue from sales of packaged software products and audio practice products is recognized as the products are shipped and title passes and risks of loss have been transferred. For many product sales, these criteria are met at the time the product is shipped. For some sales to resellers and certain other sales, the Company defers revenue until the customer receives the product because the Company legally retains a portion of the risk of loss on these sales during transit. In other cases where packaged software products are sold to resellers on a consignment basis, revenue is recognized for these consignment transactions once the end user sale has occurred, assuming the remaining revenue recognition criteria have been met. In accordance with ASC subtopic 605-50, Revenue Recognition: Customer Payments and Incentives (“ASC 605-50”), cash sales incentives to resellers are accounted for as a reduction of revenue, unless a specific identified benefit is identified and the fair value is reasonably determinable. Price protection for changes in the manufacturer suggested retail value granted to resellers for the inventory that they have on hand at the date the price protection is offered is recorded as a reduction to revenue at the time of sale.
The Company offers customers the ability to make payments for packaged software purchases in installments over a period of time, which typically ranges between three and five months. Given that these installment payment plans are for periods less than 12 months, a successful collection history has been established and these fees are fixed and determinable, revenue is recognized at the time of sale, assuming the remaining revenue recognition criteria have been met.
In connection with packaged software product sales and web-based software subscriptions, technical support is provided to customers, including customers of resellers, via telephone support at no additional cost for up to six months from the time of purchase. As the fee for technical support is included in the initial licensing fee, the technical support and services are generally provided within one year, the estimated cost of providing such support is deemed insignificant and no unspecified upgrades/enhancements are offered, technical support revenue is recognized together with the software product and web-based software subscription revenue. Costs associated with the technical support are accrued at the time of sale.
Sales commissions from non-cancellable web-based software subscription contracts are deferred and amortized in proportion to the revenue recognized from the related contract.
Restructuring Costs
In the first quarter of 2015, the Company announced and initiated actions to reduce headcount and other costs in order to support its strategic shift in business focus. In connection with this plan, the Company incurred restructuring related costs, including employee severance and related benefit costs, contract termination costs, and other related costs. These costs are included in our operating expense line items on the Statement of Operations.
Employee severance and related benefit costs primarily include cash payments, outplacement services, continuing health insurance coverage, and other benefits. Where no substantive involuntary termination plan previously exists, these severance costs are generally considered “one-time” benefits and recognized at fair value in the period in which a detailed plan has been approved by management and communicated to the terminated employees. Severance costs pursuant to ongoing benefit arrangements, including termination benefits provided for in existing employment contracts, are recognized when probable and reasonably estimable.
Contract termination costs include penalties to cancel certain service and license contracts. Contract termination costs are recognized at fair value in the period in which the contract is terminated in accordance with the contract terms.
Other related costs generally include external consulting and legal costs associated with the strategic shift in business focus of the Company’s Consumer business. Such costs are recognized at fair value in the period in which the costs are incurred.

9

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Income Taxes
The Company accounts for income taxes in accordance with ASC topic 740, Income Taxes ("ASC 740"), which provides for an asset and liability approach to accounting for income taxes. Deferred tax assets and liabilities represent the future tax consequences of the differences between the financial statement carrying amounts of assets and liabilities versus the tax basis of assets and liabilities. Under this method, deferred tax assets are recognized for deductible temporary differences, and operating loss and tax credit carryforwards. Deferred liabilities are recognized for taxable temporary differences. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The impact of tax rate changes on deferred tax assets and liabilities is recognized in the year that the change is enacted.
Deferred Tax Valuation Allowance
The Company has recorded a valuation allowance offsetting certain of its deferred tax assets as of March 31, 2015. When measuring the need for a valuation allowance on a jurisdiction by jurisdiction basis, the Company assesses both positive and negative evidence regarding whether these deferred tax assets are realizable. In determining deferred tax assets and valuation allowances, the Company is required to make judgments and estimates related to projections of profitability, the timing and extent of the utilization of temporary differences, net operating loss carryforwards, tax credits, applicable tax rates, transfer pricing methodologies and tax planning strategies. The valuation allowance is reviewed quarterly and is maintained until sufficient positive evidence exists to support a reversal. Because evidence such as the Company’s operating results during the most recent three-year period is afforded more weight than forecasted results for future periods, the Company’s cumulative loss in certain jurisdictions represents significant negative evidence in the determination of whether deferred tax assets are more likely than not to be utilized in certain jurisdictions. This determination resulted in the need for a valuation allowance on the deferred tax assets of certain jurisdictions. The Company will release this valuation allowance when it is determined that it is more likely than not that its deferred tax assets will be realized. Any future release of valuation allowance may be recorded as a tax benefit increasing net income.
Fair Value of Financial Instruments
The Company values its assets and liabilities using the methods of fair value as described in ASC topic 820, Fair Value Measurements and Disclosures, ("ASC 820"). ASC 820 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The three levels of fair value hierarchy are described below:
Level 1: Quoted prices for identical instruments in active markets.
Level 2: Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.
Level 3: Significant inputs to the valuation model are unobservable.
The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, restricted cash, accounts receivable, accounts payable and other accrued expenses approximate fair value due to relatively short periods to maturity.
Business Combinations
The Company recognizes all of the assets acquired, liabilities assumed and contractual contingencies from an acquired company as well as contingent consideration at fair value on the acquisition date. The excess of the total purchase price over the fair value of the assets and liabilities acquired is recognized as goodwill. Acquisition-related costs are recognized separately from the acquisition and expensed as incurred. Generally, restructuring costs incurred in periods subsequent to the acquisition date are expensed when incurred. Subsequent changes to the purchase price (i.e., working capital adjustments) or other fair value adjustments determined during the measurement period are recorded as adjustments to goodwill.
Stock-Based Compensation
The Company accounts for its stock-based compensation in accordance ASC topic 718, Compensation—Stock Compensation ("ASC 718"). Under ASC 718, all stock-based awards, including employee stock option grants, are recorded at fair value as of the grant date and recognized as expense in the statement of operations on a straight-line basis over the requisite service period, which is the vesting period. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model.

10

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

The Company reviews a group of comparable industry-related companies and its own data to estimate its expected volatility over the most recent period commensurate with the estimated expected term of the awards. In addition to analyzing our own and peer group data, the Company also considers the contractual option term and vesting period when determining the expected option life and forfeiture rate. The Company estimates the expected term of options using a combination of peer company information and the simplified method for estimating the expected term. For the risk-free interest rate, the Company uses a U.S. Treasury Bond rate consistent with the estimated expected term of the option award.
The Company’s restricted stock and restricted stock unit grants are accounted for as equity awards. The grant date fair value is based on the market price of the Company’s common stock at the date of grant.
Foreign Currency Translation and Transactions
The functional currency of the Company's foreign subsidiaries is their local currency. Accordingly, assets and liabilities of the foreign subsidiaries are translated into U.S. dollars at exchange rates in effect on the balance sheet date. Income and expense items are translated at average rates for the period. Translation adjustments are recorded as a component of other comprehensive income (loss) in stockholders' equity.
Cash flows of consolidated foreign subsidiaries, whose functional currency is their local currency, are translated to U.S. dollars using average exchange rates for the period. The Company reports the effect of exchange rate changes on cash balances held in foreign currencies as a separate item in the reconciliation of the changes in cash and cash equivalents during the period.
The following table presents the effect of exchange rate changes on total comprehensive loss (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2015
 
2014
Net loss
 
$
(19,884
)
 
$
(20,241
)
Foreign currency translation loss
 
(1,147
)
 
(364
)
Total comprehensive loss
 
$
(21,031
)
 
$
(20,605
)
Advertising Costs
Costs for advertising are expensed as incurred. Advertising expense for the three months ended March 31, 2015 and March 31, 2014 was $13.4 million and $15.7 million, respectively.
Recently Issued Accounting Standards
In April 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2015-05, "Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40): Customer's Accounting for Fees Paid in a Cloud Computing Arrangement ("ASU 2015-05"). ASU 2015-05 provides guidance regarding whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the entity should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the entity should account for the arrangement as a service contract. ASU 2015-05 does not change the accounting for service contracts. ASU 2015-05 is effective for fiscal years, including interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted. The Company does not expect to early adopt the guidance and does not believe that the adoption of this guidance will have a material impact on the Company's financial statements and disclosures.
In April 2015, the FASB issued ASU No. 2015-03, Interest - Imputation of Interest (Subtopic 835-30) Simplifying the Presentation of Debt Issuance Costs ("ASU 2015-03"). ASU 2015-03 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by the amendments in ASU 2015-03. ASU 2015-03 will be effective for interim and annual financial statements issued for fiscal years beginning after December 15, 2015. Early adoption is permitted for financial statements that have not been previously issued. The Company does not believe that the adoption of this guidance will have a material impact on the Company's financial statements and disclosures.

11

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

In August 2014, the FASB issued ASU No. 2014-15, Presentation of Financial Statements - Going Concern (Subtopic 205-40) ("ASU 2014-15"). ASU 2014-15 addresses management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. Management’s evaluation should be based on relevant conditions and events that are known and reasonably knowable at the date that the financial statements are issued. ASU 2014-15 will be effective for the first interim period within annual reporting periods beginning after December 15, 2016. Early adoption is permitted. The Company does not expect to early adopt this guidance and does not believe that the adoption of this guidance will have a material impact on the Company's financial statements and disclosures.
In June 2014, the FASB issued ASU No. 2014-12, Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period ("ASU 2014-12"). ASU 2014-12 requires that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. ASU 2014-12 is effective for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2015. Early adoption is permitted. The Company does not expect to early adopt this guidance and does not believe that the adoption of this guidance will have a material impact on the Company's financial statements and disclosures.
In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) ("ASU 2014-09"), which replaces the current revenue accounting guidance. ASU 2014-09 is effective for annual periods beginning after December 15, 2016. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity should apply a five step model to 1) identify the contract(s) with a customer, 2) identify the performance obligations in the contract, 3) determine the transaction price, 4) allocate the transaction price to the performance obligations in the contract and 5) recognize revenue when (or as) the entity satisfies a performance obligation. Entities may choose from two adoption methods, with certain practical expedients. The Company is in the process of evaluating the impact of the new guidance on the Company's financial statements and disclosures and the adoption method.
3. BUSINESS COMBINATIONS
In January 2014, the Company acquired Vivity Labs, Inc. and Tell Me More S.A. Under the acquisition method of accounting, the total purchase price was allocated to the tangible and intangible assets acquired on the basis of their respective estimated fair values at the date of acquisition. The valuation of the identifiable intangible assets and their useful lives acquired reflects management's estimates.
Vivity Labs Inc.
On January 2, 2014, the Company completed its acquisition of Vivity Labs Inc. (the "Vivity Labs Merger" and "Vivity"). Vivity’s principal business activity is the development of brain fitness games aimed at improving the user’s cognitive function through activity, awareness and motivation through its flagship product, Fit Brains. The applications are designed for use on mobile, web and social platforms. Vivity’s emphasis on mobile solutions is especially compatible with Rosetta Stone’s focus on cloud-based technology to enable on-the-go learning. The aggregate amount of consideration paid by the Company was $12.2 million in cash.
The acquisition of Vivity resulted in goodwill of approximately $9.3 million, none of which is deductible for tax purposes. This amount represents the residual amount of the total purchase price after allocation to the assets acquired and liabilities assumed.
All expenditures incurred in connection with the Vivity Labs Merger were expensed and are included in general and administrative expenses. Transaction costs incurred in connection with the Vivity Labs Merger were zero and $15,000 during the three months ended March 31, 2015 and 2014, respectively. The results of operations for Vivity have been included in the consolidated results of operations since January 2, 2014.
The Company has allocated the purchase price based on current estimates of the fair values of assets acquired and liabilities assumed in connection with the Vivity Labs Merger. The table below summarizes the estimates of fair value of the Vivity Labs assets acquired, liabilities assumed and related deferred income taxes as of the acquisition date.

12

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
3. BUSINESS COMBINATIONS (Continued)

The Company finalized its allocation of the purchase price for Vivity as of December 31, 2014. The purchase price was allocated as follows (in thousands):
Cash
 
$
14

Accounts receivable
 
452

Other current assets
 
(3
)
Accounts payable and accrued expenses
 
(307
)
Net deferred tax liability
 
(919
)
Net tangible assets acquired
 
(763
)
Goodwill
 
9,336

Amortizable intangible assets
 
3,577

Purchase price
 
$
12,150

The acquired amortizable intangible assets and the related estimated useful lives consist of the following (in thousands):
 
 
Estimated Useful Lives
 
Estimated Value January 2, 2014
Tradename
 
3 years
 
$
188

Technology platform
 
5 years
 
2,448

Customer relationships
 
3 years
 
941

Total assets
 
 
 
$
3,577

Tell Me More S.A.
On January 9, 2014, the Company completed its acquisition of Tell Me More S.A., (the "Tell Me More Merger" and "Tell Me More") a company organized under the laws of France. Tell Me More provides online language-learning subscriptions and learning services primarily to corporate and educational organizations. Tell Me More offers a robust suite of SaaS-based language-learning products and services that provide intermediate, advanced and business language solutions in nine languages. The Tell Me More Merger strengthens the Company's growing Enterprise & Education business and expands its global footprint. The aggregate amount of consideration paid by the Company was €22.1 million ($30.2 million), including assumed net debt.
The Tell Me More Merger resulted in goodwill of approximately $21.7 million, none of which is deductible for tax purposes. This amount represents the residual amount of the total purchase price after allocation to the assets acquired and liabilities assumed.
All expenditures incurred in connection with the Tell Me More Merger were expensed and are included in general and administrative expenses. Transaction costs incurred in connection with the Tell Me More Merger were zero and $0.5 million during the three months ended March 31, 2015 and 2014, respectively. The results of operations for Tell Me More have been included in the consolidated results of operations since January 9, 2014.
The Company has allocated the purchase price based on current estimates of the fair values of assets acquired and liabilities assumed in connection with the Tell Me More Merger. The table below summarizes the estimates of fair value of the Tell Me More assets acquired, liabilities assumed and related deferred income taxes as of the acquisition date.

13

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
3. BUSINESS COMBINATIONS (Continued)

The Company finalized its allocation of the purchase price for Tell Me More as of December 31, 2014. The purchase price was allocated as follows (in thousands):
Cash
 
$
2,323

Accounts receivable
 
2,979

Inventory
 
246

Prepaid expenses
 
243

Fixed assets
 
5,595

Other non-current assets
 
330

Accounts payable
 
(732
)
Accrued compensation
 
(2,855
)
Deferred revenue
 
(2,190
)
Other current liabilities
 
(1,211
)
Obligation under capital lease
 
(3,958
)
Net deferred tax liability
 
(1,392
)
Net tangible assets acquired
 
(622
)
Goodwill
 
21,703

Amortizable intangible assets
 
9,105

Purchase price
 
$
30,186

The acquired amortizable intangible assets and the related estimated useful lives consist of the following (in thousands):
 
 
Estimated Useful Lives
 
Estimated Value January 9, 2014
Customer relationships
 
5 years
 
$
4,348

Technology platform
 
5 years
 
4,144

Tradename
 
1 year
 
613

Total assets
 
 
 
$
9,105

Pro Forma Adjusted Summary
The results of Vivity and Tell Me More’s operations have been included in the consolidated financial statements subsequent to the acquisition dates.
The following schedule presents unaudited consolidated pro forma results of operations data as if the Vivity Labs and Tell Me More Mergers had occurred on January 1, 2013 (collectively "the Mergers"). This information does not purport to be indicative of the actual results that would have occurred if the Mergers had actually been completed on the date indicated, nor is it necessarily indicative of the future operating results or the financial position of the combined company (in thousands, except per share amounts):
 
 
Three Months Ended 
 March 31,
 
 
2015
 
2014
Revenue
 
$
58,650

 
$
63,830

Net loss
 
$
(19,660
)
 
$
(17,020
)
Basic loss per share
 
$
(0.94
)
 
$
(0.81
)
Diluted loss per share
 
$
(0.94
)
 
$
(0.81
)

14

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
3. BUSINESS COMBINATIONS (Continued)

The operations of Tell Me More have been integrated into the overall operations of the Company. The results of Tell Me More are reported within the results of the Company’s operating segments and are not recorded on a stand-alone basis. Therefore, it is impracticable to report revenue and earnings from Tell Me More for the three months ended March 31, 2015. Revenue and net loss from Vivity were $1.1 million and $0.6 million for the three months ended March 31, 2015, respectively.
4. NET LOSS PER SHARE
 Net loss per share is computed under the provisions of ASC topic 260, Earnings Per Share. Basic loss per share is computed using net loss and the weighted average number of shares of common stock outstanding. Diluted earnings per share reflect the weighted average number of shares of common stock outstanding plus any potentially dilutive shares outstanding during the period. Potentially dilutive shares consist of shares issuable upon the exercise of stock options, restricted stock awards, restricted stock units and conversion of shares of preferred stock. Common stock equivalent shares are excluded from the diluted computation if their effect is anti-dilutive.
The following table sets forth the computation of basic and diluted net loss per common share (in thousands, except per share amounts):
 
 
 
Three Months Ended 
 March 31,
 
 
2015

2014
Numerator:
 
 
 
 
Net Loss
 
$
(19,884
)
 
$
(20,241
)
Denominator:
 
 
 
 
Weighted average number of common shares:
 
 
 
 
Basic
 
21,018

 
21,125

Diluted
 
21,018

 
21,125

Loss per common share:
 
 
 
 
Basic
 
$
(0.95
)
 
$
(0.96
)
Diluted
 
$
(0.95
)
 
$
(0.96
)
For the three months ended March 31, 2015 and 2014, no common stock equivalent shares were included in the calculation of the Company’s diluted net income per share.
The following is a summary of common stock equivalents for the securities outstanding during the respective periods that have been excluded from the earnings per share calculations as their impact was anti-dilutive.
 
 
Three Months Ended 
 March 31,
 
 
2015
 
2014
Stock options
 
58,000

 
113,000

Restricted stock units
 
119,000

 
87,000

Restricted stocks
 
69,000

 
86,000

Total common stock equivalent shares
 
246,000

 
286,000

 

15

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
5. INVENTORY


Inventory consisted of the following (in thousands):
 
 
March 31,
2015
 
December 31,
2014
Raw materials
 
$
4,584

 
$
3,163

Finished goods
 
3,824

 
3,337

Total inventory
 
$
8,408

 
$
6,500

6. GOODWILL
The value of goodwill is primarily derived from the acquisition of Rosetta Stone Ltd. (formerly known as Fairfield & Sons, Ltd.) in January 2006, the acquisition of certain assets of SGLC International Co. Ltd ("SGLC") in November 2009, the acquisitions of Livemocha, Inc. ("Livemocha") in April 2013, Lexia Learning Systems, Inc. ("Lexia") in August 2013, and the acquisitions of Vivity and Tell Me More in January 2014.
The Company tests goodwill for impairment annually on June 30 of each year at the reporting unit level using a fair value approach, in accordance with the provisions of ASC topic 350, Intangibles - Goodwill and other ("ASC 350"), or more frequently, if impairment indicators arise.
The following table shows the balance and changes in goodwill for the Company's operating segments for the three months ended March 31, 2015 (in thousands):
 
 
Consumer
 
Enterprise & Education
 
Total
Balance as of December 31, 2014
 
$
8,538

 
$
50,046

 
$
58,584

Effect of change in foreign currency rate
 
(699
)
 
(1,483
)
 
(2,182
)
Balance as of March 31, 2015
 
$
7,839

 
$
48,563

 
$
56,402

North America Consumer Language Goodwill Impairment
As discussed in more detail in Note 6 "Goodwill" to the Company’s 2014 audited consolidated financial statements, during the fourth quarter ended December 31, 2014, the Company determined sufficient indicators existed to require performance of an interim goodwill impairment analysis as of December 31, 2014 for the North America Consumer Language reporting unit. This indicator was due to reduced demand, sustained price declines, and the Company's overall change in long-term strategy to focus on the Enterprise & Education segment. In this interim goodwill impairment test, the second step of the goodwill impairment test was performed and resulted in the North America Consumer Language reporting unit having a negative implied fair value of goodwill. As a result, the Company recorded its best estimate of the goodwill impairment loss of $18.0 million, which represented a full impairment of North America Consumer Language’s goodwill. In the first quarter of 2015, the Company finalized the measurement of the impairment charge with no adjustment to the estimated impairment loss initially recorded in 2014.
Interim Impairment Review
The Company routinely reviews goodwill at the reporting unit level for potential impairment as part of the Company’s internal control framework. All reporting units with remaining goodwill balances were evaluated to determine if a triggering event has occurred. As of March 31, 2015, the Company concluded that there are no indicators of impairment that would cause the Company to believe that it is more likely than not that the fair value of our reporting units is less than the carrying value. Accordingly, a detailed impairment test has not been performed and no goodwill impairment charges were recorded in connection with the interim impairment review.

16

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


7. INTANGIBLE ASSETS
Intangible assets consisted of the following items as of the dates indicated (in thousands):
 
 
March 31, 2015
 
December 31, 2014
 
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Net
Carrying
Amount
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Net
Carrying
Amount
Tradename/trademark *
 
$
12,453

 
$
(1,087
)
 
$
11,366

 
$
12,526

 
$
(1,062
)
 
$
11,464

Core technology
 
15,303

 
(6,127
)
 
9,176

 
15,890

 
(5,661
)
 
10,229

Customer relationships
 
26,394

 
(14,862
)
 
11,532

 
26,889

 
(14,344
)
 
12,545

Website
 
12

 
(12
)
 

 
12

 
(12
)
 

Patents
 
300

 
(171
)
 
129

 
300

 
(161
)
 
139

Total
 
$
54,462

 
$
(22,259
)
 
$
32,203

 
$
55,617

 
$
(21,240
)
 
$
34,377

* Included in the tradename/trademark line above is the Rosetta Stone tradename, which is the Company's only indefinite-lived intangible asset. As of March 31, 2015, the carrying value of the tradename asset was $10.6 million.
Amortization Expense for the Long-lived Intangible Assets
The following table presents amortization of intangible assets included in the related financial statement line items during the respective periods (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2015
 
2014
Included in cost of revenue:
 
 
 
 
Cost of product revenue
 
$
79

 
$

Cost of subscription and service revenue
 
67

 
146

Total included in cost of revenue
 
146

 
146

Included in operating expenses:
 
 
 
 
Sales and marketing
 
725

 
933

Research and development
 
456

 
485

General and administrative
 

 

Total included in operating expenses
 
1,181

 
1,418

Total
 
$
1,327

 
$
1,564

The following table summarizes the estimated future amortization expense related to intangible assets for the remaining nine months of 2015 and years thereafter (in thousands):
 
 
As of March 31, 2015
2015 - remaining
 
$
3,855

2016
 
4,683

2017
 
4,214

2018
 
3,601

2019
 
1,532

Thereafter
 
3,710

Total
 
$
21,595



17

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
7. INTANGIBLE ASSETS (Continued)

Impairment Reviews of Intangible Assets
The Company also routinely reviews indefinite-lived intangible assets and long-lived assets for potential impairment as part of the Company’s internal control framework. As an indefinite-lived intangible asset, the Rosetta Stone tradename was evaluated as of March 31, 2015 to determine if indicators of impairment exist. The Company concluded that there were no potential indicators of impairment related to this indefinite-lived intangible asset. Additionally all long-lived intangible assets were evaluated to determine if indicators of impairment exist and the Company concluded that there are no potential indicators of impairment.
8. OTHER CURRENT LIABILITIES
The following table summarizes other current liabilities (in thousands):
 
 
March 31, 2015
 
December 31, 2014
Accrued marketing expenses
 
$
23,354

 
$
31,985

Accrued professional and consulting fees
 
3,571

 
2,804

Sales return reserve
 
2,660

 
3,570

Sales, withholding and property taxes payable
 
4,603

 
5,875

Accrued purchase price of business acquisition
 

 
1,688

Other
 
10,726

 
10,235

Total other current liabilities
 
$
44,914

 
$
56,157

9. FINANCING ARRANGEMENTS
Revolving Line of Credit
On October 28, 2014, Rosetta Stone Ltd (“RSL”), a wholly owned subsidiary of parent company Rosetta Stone Inc., executed a Loan and Security Agreement with Silicon Valley Bank (“Bank”) to obtain a $25 million revolving credit facility (the “credit facility”). Borrowings by RSL under the credit facility are guaranteed by the Company as the ultimate parent. The credit facility has a term of three years during which RSL may borrow and re-pay loan amounts and re-borrow the loan amounts subject to customary borrowing conditions. RSL may elect to have interest on borrowed amounts accrue at either a LIBOR rate plus a margin of 2.25% percent or a prime rate plus a margin of 1.25% percent. RSL may select LIBOR interest periods of certain defined intervals ranging from one month to one year. All portions of outstanding loans may be converted from one interest rate method to the other. Proceeds of loans made under the credit facility may be used as working capital or to fund general business requirements.
All obligations under the credit facility are secured by a security interest on substantially all of the Company’s assets including intellectual property rights and by a stock pledge by the Company of 100% of its ownership interests in U.S. subsidiaries and 66% of its ownership interests in certain foreign subsidiaries.
The Company is subject to certain financial and restrictive covenants under the credit facility. The credit facility contains customary affirmative and negative covenants, including covenants that limit or restrict our ability to, among other things, incur additional indebtedness, dispose of assets, execute a material change in business, acquire or dispose of an entity, grant liens, make share repurchases, and make distributions, including payment of dividends. The Company is required to maintain compliance with a minimum liquidity ratio and maintain a minimum Adjusted EBITDA. To date, the Company was in compliance with all covenants.
The credit facility contains customary events of default, including among others, non-payment defaults, covenant defaults, bankruptcy and insolvency defaults, and a change of control default, in each case, subject to customary exceptions. The occurrence of a default event could result in the Bank’s acceleration of repayment obligations of any loan amounts then outstanding.
The Company executed the First Amendment to the credit facility with the Bank effective March 31, 2015 and the Second Amendment to the credit facility with the Bank effective May 1, 2015. The Company is subject to certain covenants

18

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
9. FINANCING ARRANGEMENTS (Continued)


under the Loan and Security Agreement including financial covenants and limitations on indebtedness, encumbrances, investments and distributions and dispositions of assets, certain of which covenants were amended to reflect the revised outlook the Company previously communicated on the March 11, 2015 earnings conference call.
As of March 31, 2015, there were no borrowings outstanding and the Company was eligible to borrow the entire $25 million of available credit. A quarterly commitment fee accrues on any unused portion of the credit facility at a nominal annual rate.
Capital Leases
The Company enters into capital leases under non-committed arrangements for equipment and software. In addition, as a result of the Tell Me More Merger, the Company assumed a capital lease for a building near Versailles, France, where Tell Me More’s headquarters are located. The fair value of the lease liability at the date of acquisition was $4.0 million.
During the three months ended March 31, 2015 and 2014, the Company acquired no equipment or software through the issuance of capital leases.
Future minimum payments under capital leases with initial terms of one year or more are as follows (in thousands):
 
 
As of March 31, 2015
2015-remaining
 
$
373

2016
 
492

2017
 
492

2018
 
485

2019
 
485

Thereafter
 
1,333

Total minimum lease payments
 
$
3,660

Less amount representing interest
 
577

Present value of net minimum lease payments
 
$
3,083

Less current portion
 
361

Obligations under capital lease, long-term
 
$
2,722

10. INCOME TAXES
In accordance with ASC topic 740, Income Taxes (“ASC 740”), and ASC subtopic 740-270, Income Taxes: Interim Reporting, the income tax provision for the three months ended March 31, 2015 is based on the estimated annual effective tax rate for fiscal year 2015. The estimated effective tax rate may be subject to adjustment in subsequent quarterly periods as the estimates of pretax income for the year, along with other items that may affect the rate, may change and may create a different relationship between domestic and foreign income and loss.
The Company accounts for uncertainty in income taxes under ASC subtopic 740-10-25, Income Taxes: Overall: Background (“ASC 740-10-25”). ASC 740-10-25 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC 740-10-25 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.
As of March 31, 2015, the Company is under audit in the United States for the income tax years 2009 to 2012. Currently the Company expects the IRS audit to be completed in 2015 and will provide additional information at that time. While the ultimate results cannot be predicted with certainty, the Company believes that the resulting adjustments, if any, will not have a material adverse effect on its consolidated financial condition or results of operations.
As of March 31, 2015 and December 31, 2014, the Company had $446,000 and $446,000, respectively, of unrecognized tax benefits, which if recognized, $51,000 would affect income tax expense. These liabilities for unrecognized tax benefits are presented as a reduction to the related deferred tax asset where appropriate and the remaining amount is included in “Income Taxes Payable.” Interest and penalties related to uncertain tax positions are recorded as part of the income tax provision. As of

19

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
10. INCOME TAXES (Continued)

March 31, 2015, the Company had accrued approximately $28,000 in "Income Taxes Payable", compared to $26,000 as of December 31, 2014.
Valuation Allowance Recorded for Deferred Tax Assets
The Company evaluates the recoverability of its deferred tax assets at each reporting period for each tax jurisdiction and establishes a valuation allowance, if necessary, to reduce the deferred tax asset to an amount that is more likely than not to be recovered. As of March 31, 2015, the analysis of the need for a valuation allowance on U.S. deferred tax assets considered that the U.S. entity has incurred a three-year cumulative loss. As previously disclosed, if the Company does not have sufficient objective positive evidence to overcome a three-year cumulative loss, a valuation allowance may be necessary. In evaluating whether to record a valuation allowance, the guidance in ASC 740 deems that the existence of cumulative losses in recent years is a significant piece of objectively verifiable negative evidence that is difficult to overcome. An enterprise that has cumulative losses is generally prohibited from using an estimate of future earnings to support a conclusion that realization of an existing deferred tax asset is more likely than not.
Consideration has been given to the following positive and negative evidence:
Three-year cumulative evaluation period ended March 31, 2015 results in a cumulative U.S. pre-tax loss;
from 2006, when the U.S. entity began filing as a C-corporation for income tax purposes, through 2010, the U.S. entity generated taxable income each year;
the Company has a history of utilizing all operating tax loss carryforwards and has not had any tax loss carryforwards or credits expire unused;
lengthy loss carryforward periods of 20 years for U.S. federal and most state jurisdictions apply; and
the Company incurred a U.S. federal jurisdiction net operating loss for the most recently completed calendar year and has additional net operating loss carryforwards subject to limitation pursuant to IRC Section 382.
As of March 31, 2015, a valuation allowance was provided for the U.S., Korea, Japan, China, Hong Kong, Mexico, Spain, France and Brazil where the Company has determined the deferred tax assets will not more likely than not be realized.
Evaluation of the remaining jurisdictions as of March 31, 2015 resulted in the determination that no additional valuation allowances were necessary at this time. However, the Company will continue to assess the need for a valuation allowance against its deferred tax assets in the future and the valuation will be adjusted accordingly, which could materially affect the Company’s financial position and results of operations.
As of March 31, 2015, and December 31, 2014, the Company’s U.S. deferred tax liability was $3.8 million and $3.5 million, respectively, related to its goodwill and indefinite lived intangibles. As of March 31, 2015 the Company had foreign net deferred tax liabilities of $0.7 million compared to net deferred tax liabilities of $0.8 million at December 31, 2014.
For the three months ended March 31, 2015 the Company recorded an income tax expense of $0.2 million. The expense in the current period is made up of tax expense related to current year profits of operations in Germany, and foreign withholding taxes recorded during the period. Additionally, the tax expense relates to the tax impact of the amortization of indefinite lived intangibles and the inability to recognize tax benefits associated with current year losses of operations in all other foreign jurisdictions and in the U.S. due to the valuation allowance recorded against the deferred tax asset balances of these entities. These tax expenses are partially offset by tax benefits related to current year losses in the U.K. and Canada.
11. STOCK-BASED COMPENSATION
2006 Stock Incentive Plan
On January 4, 2006, the Company established the Rosetta Stone Inc. 2006 Stock Incentive Plan (the "2006 Plan") under which the Company's Board of Directors, at its discretion, could grant stock options to employees and certain directors of the Company and affiliated entities. The 2006 Plan initially authorized the grant of stock options for up to 1,942,200 shares of common stock. On May 28, 2008, the Board of Directors authorized the grant of additional stock options for up to 195,000 shares of common stock under the plan, resulting in total stock options available for grant under the 2006 Plan of 2,137,200 as of December 31, 2008. The stock options granted under the 2006 Plan generally expire at the earlier of a specified period after

20

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
11. STOCK-BASED COMPENSATION (Continued)


termination of service or the date specified by the Board or its designated committee at the date of grant, but not more than ten years from such grant date. Stock issued as a result of exercises of stock options will be issued from the Company's authorized available stock.
2009 Omnibus Incentive Plan
On February 27, 2009, the Company's Board of Directors approved the 2009 Omnibus Incentive Plan (the "2009 Plan") that provides for the ability of the Company to grant up to 2,437,744 of new stock incentive awards or options including Incentive and Nonqualified Stock Options, Stock Appreciation Rights, Restricted Stock, Restricted Stock Units, Performance Units, Performance Shares, Performance based Restricted Stock, Share Awards, Phantom Stock and Cash Incentive Awards. The stock incentive awards and options granted under the 2009 Plan generally expire at the earlier of a specified period after termination of service or the date specified by the Board or its designated committee at the date of grant, but not more than ten years from such grant date. On May 26, 2011 the Board of Directors authorized and the Company's shareholders' approved the allocation of an additional 1,000,000 shares of common stock to the 2009 Plan. On May 23, 2012, the Board of Directors authorized and the Company's shareholders approved the allocation of 1,122,930 additional shares of common stock to the 2009 Plan. On May 23, 2013, the Board of Directors authorized and the Company's shareholders approved the allocation of 2,317,000 additional shares of common stock to the 2009 Plan. On May 20, 2014, the Board of Directors authorized and the Company's shareholders approved the allocation of 500,000 additional shares of common stock to the 2009 Plan.
Concurrent with the approval of the 2009 Plan, the 2006 Plan was terminated for purposes of future grants. At March 31, 2015 there were 1,755,337 shares available for future grant under the 2009 Plan.
In accordance with ASC 718, the fair value of stock-based awards to employees is calculated as of the date of grant. Compensation expense is then recognized on a straight-line basis over the requisite service period of the award. The Company uses the Black-Scholes pricing model to value its stock options, which requires the use of estimates, including future stock price volatility, expected term and forfeitures. Stock-based compensation expense recognized is based on the estimated portion of the awards that are expected to vest. Estimated forfeiture rates were applied in the expense calculation.
For the three months ended March 31, 2015 and 2014, the fair value of options granted was calculated using the following assumptions:  
 
 
Three Months Ended 
 March 31,
 
 
2015
 
2014
Expected stock price volatility
 
62.6%-63.1%
 
63.7%-64.2%
Expected term of options
 
6 years
 
6 years
Expected dividend yield
 
 
Risk-free interest rate
 
1.19%-1.57%
 
1.46%-1.72%

21

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
11. STOCK-BASED COMPENSATION (Continued)


The following table presents stock-based compensation expense included in the related financial statement line items (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2015
 
2014
Included in cost of revenue:
 
 
 
 
Cost of product revenue
 
$
22

 
$

Cost of subscription and service revenue
 
11

 

Total included in cost of revenue
 
33

 

Included in operating expenses:
 
 
 
 
Sales and marketing
 
361

 
428

Research and development
 
140

 
127

General and administrative
 
753

 
851

Total included in operating expenses
 
1,254

 
1,406

Total
 
$
1,287

 
$
1,406

Stock Options
The following table summarizes the Company's stock option activity from January 1, 2015 to March 31, 2015:
 
 
Options
Outstanding
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Contractual
Life (years)
 
Aggregate
Intrinsic
Value
Options Outstanding, January 1, 2015
 
2,017,642

 
$
13.24

 
7.32
 
$
760,925

Options granted
 
609,966

 
9.76

 
 
 
 
Options exercised
 
(4,924
)
 
7.44

 
 
 
 
Options canceled
 
(72,908
)
 
12.99

 
 
 
 
Options Outstanding, March 31, 2015
 
2,549,776

 
12.43

 
6.96
 
273,190

Vested and expected to vest March 31, 2015
 
2,251,389

 
12.63

 
6.77
 
273,161

Exercisable at March 31, 2015
 
1,167,648

 
$
13.95

 
5.49
 
$
272,800

As of March 31, 2015, there was approximately $7.4 million of unrecognized stock-based compensation expense related to non-vested stock option awards that is expected to be recognized over a weighted average period of 2.94 years.
Stock options are granted at the discretion of the Board of Directors or the Compensation Committee (or its authorized member(s)) and expire 10 years from the date of the grant. Options generally vest over a four-year period based upon required service conditions. No options have performance or market conditions. The Company calculates the pool of additional paid-in capital associated with excess tax benefits using the "simplified method" in accordance with ASC 718.

22

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
11. STOCK-BASED COMPENSATION (Continued)


Restricted Stock Awards
The following table summarizes the Company's restricted stock award activity from January 1, 2015 to March 31, 2015:
 
 
Nonvested
Outstanding
 
Weighted
Average
Grant Date
Fair Value
 
Aggregate
Intrinsic
Value
Nonvested Awards, January 1, 2015
 
482,645

 
$
12.59

 
$
6,074,136

Awards granted
 
367,313

 
9.56

 
 

Awards vested
 
(265,590
)
 
10.32

 
 

Awards canceled
 
(37,546
)
 
12.86

 
 

Nonvested Awards, March 31, 2015
 
546,822

 
$
11.63

 
$
6,356,915

As of March 31, 2015, future compensation cost related to the nonvested portion of the restricted stock awards not yet recognized in the consolidated statement of operations was $5.6 million and is expected to be recognized over a period of 2.83 years.
Restricted stock awards are granted at the discretion of the Board of Directors or Compensation Committee (or its authorized member(s)). Restricted stock awards generally vest over a four-year period based upon required service conditions.
Restricted Stock Units
During the three months ended March 31, 2015, there were no restricted stock units granted. The Company did not grant any restricted stock units prior to April 2009.
Long Term Incentive Program
On February 21, 2013, the Company’s board of directors approved the 2013 Rosetta Stone Inc. Long Term Incentive Program (“2013 LTIP”). The 2013 LTIP was administered under the 2009 Plan and the shares awarded under the 2013 LTIP were taken from the shares reserved under the 2009 Plan. The 2013 LTIP was effective from January 1, 2013 through December 31, 2014.
The amount of share-based and cash-based compensation expense recognized related to the 2013 LTIP was $0.6 million and $0.1 million, respectively, for the three months ended March 31, 2014. During the first quarter of 2015, the Company issued 160,860 performance share awards related to the conclusion of the 2013 LTIP.
12. STOCKHOLDERS' EQUITY
At March 31, 2015, the Company's board of directors had the authority to issue 200,000,000 shares of stock, of which 190,000,000 were designated as Common Stock, with a par value of $0.00005 per share, and 10,000,000 were designated as Preferred Stock, with a par value of $0.001 per share. At March 31, 2015, the Company had shares of common stock issued of 23,268,069 and shares of common stock outstanding of 22,268,069.
On May 8, 2013, the Company filed a universal shelf registration statement which became effective on May 30, 2013. The registration statement permitted certain holders of the Company’s stock to offer the shares of common stock held by them. On June 11, 2013 the selling shareholders, ABS Capital Partners IV Trust and Norwest Equity Partners VIII, LP, sold a combined total of 3,490,000 shares at an offering price of $16.00 per share. During November and December 2013, ABS Capital Partners IV Trust sold the remainder of its common stock holdings in the Company. The shelf registration statement also provides the Company with the flexibility to offer an amount of equity or issue debt in the amount of $150.0 million. The Company issued and sold an additional 10,000 shares of common stock at a per share price of $16.00 in the offering.
On August 22, 2013, the Company’s Board of Directors approved a share repurchase program under which the Company is authorized to repurchase up to $25 million of its outstanding common stock from time to time in the open market or in privately negotiated transactions depending on market conditions, other corporate considerations, debt facility covenants and other contractual limitations, and applicable legal requirements. The Company expects to fund the repurchases through existing cash balances and cash generated from operations. For the year ended December 31, 2013, the Company paid $11.4 million to repurchase 1.0 million shares at a weighted average price of $11.44 per share as part of this program. No shares were

23

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
12. STOCKHOLDERS' EQUITY (Continued)


repurchased during 2014 or the three months ended March 31, 2015. Shares repurchased under the program were recorded as treasury stock on the Company’s consolidated balance sheet. The shares repurchased under this program during the year ended December 31, 2013 were not the result of an accelerated share repurchase agreement. Management has not made a decision on whether shares purchased under this program will be retired or reissued.
13. RESTRUCTURING
In the first quarter of 2015, the Company announced and initiated actions to reduce headcount and other costs in order to support its strategic shift in business focus. The Company committed to the 2015 Restructuring Plan and has completed a large portion of the plan as of March 31, 2015. The Company expects to be substantially completed by the end of 2015.
Restructuring charges included in the Company’s unaudited consolidated statement of operations related to the 2015 Restructuring Plan and include the following:
Employee severance and related benefits costs incurred in connection with headcount reductions involving employees primarily in the U.S. and the U.K.;
Contract termination costs; and
Other related costs.
As a result of the restructuring activities, the Company has evaluated its inventory obsolescence and excess reserve, sales return and promotional reserves, the useful lives of certain of its long-term assets, and its reportable segments and reporting units. Any changes in these areas were not included as a restructuring expense or liability.
The following table summarizes activity with respect to the restructuring charges for the 2015 Restructuring Plan during the three months ended March 31, 2015 (in thousands):
 
 
Balance at January 1, 2015
 
Cost Incurred
 
Cash Payments
 
Other Adjustments (1)
 
Balance at March 31, 2015
Severance costs
 
$

 
$
6,013

 
$
(860
)
 
$
(145
)
 
$
5,008

Contract termination costs
 

 

 

 

 

Other costs
 

 
246

 

 

 
246

Total
 
$

 
$
6,259

 
$
(860
)
 
$
(145
)
 
$
5,254

(1) Other Adjustments includes non-cash period changes in the liability balance, which may include non-cash stock compensation expense and foreign currency translation adjustments.
The following table summarizes the major types of costs associated with the 2015 Restructuring Plan for the three months ended March 31, 2015 and 2014, and total costs incurred through March 31, 2015 (in thousands):
 
 
Three Months Ended March 31,
 
 
 
 
2015
 
2014
 
Incurred to Date
Severance costs
 
$
6,013

 
$

 
$
6,013

Contract termination costs
 

 

 

Other costs
 
246

 

 
246

Total
 
$
6,259

 
$

 
$
6,259

As of March 31, 2015, the entire restructuring liability of $5.3 million was classified as a current liability within accrued compensation and other current liabilities on the consolidated balance sheets.

24

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
13. RESTRUCTURING (Continued)


The following table presents restructuring costs included in the related line items of our Statement of Operations (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2015
 
2014
Cost of revenue
 
$
37

 
$

Sales and marketing
 
3,124

 

Research and development
 
604

 

General and administrative
 
2,494

 

Total
 
$
6,259

 
$

These restructuring expenses are not allocated to any reportable segment under our definition of segment contribution as defined in Note 16 "Segment Information."
In connection with the 2015 Restructuring Plan, the Company may incur contract termination costs. The Company expects to work with vendors to mitigate these termination costs. As of the filing of these financial statements, the range of loss associated with terminated contracts cannot be reasonably estimated. As a result, as of March 31, 2015, the Company cannot estimate its total restructuring expenses to be incurred in future periods under the 2015 Restructuring Plan.
At each reporting date, the Company will evaluate its accrued restructuring costs to ensure the liabilities reported are still appropriate. Any changes to the estimated costs of executing approved restructuring plans will be reflected in the Company’s Consolidated Statements of Operations.
14. LEASE ABANDONMENT AND TERMINATION
As part of the Company’s effort to reduce general and administrative expenses through a planned space consolidation at its Arlington, Virginia headquarters location, the Company incurred lease abandonment charges of zero and $3.1 million during the three months ended March 31, 2015 and 2014, respectively. Prior to January 31, 2014, the Company occupied the 6th and 7th floors at its Arlington, Virginia headquarters. The Company estimated the liability under operating lease agreements and accrued lease abandonment costs in accordance with ASC 420, Exit or Disposal Cost Obligation ("ASC 420"), as the Company has no future economic benefit from the abandoned space and the lease does not terminate until December 31, 2018. All leased space related to the 6th floor was abandoned and ceased to be used by the Company on January 31, 2014.
In March 2013 Rosetta Stone Japan Inc. partially abandoned its Japan office as a result of excess office space due to reduction in staff along with overall local operations business performance. The Company estimated the liability under the operating lease agreement reduced for anticipated sublease income in accordance with ASC 420 as the Company had no future economic benefit from the abandoned space associated with the lease terminated on February 28, 2015. As of March 31, 2014, the Company ceased to use the remaining office space in this facility and simultaneously negotiated and paid a lease termination fee of $0.4 million. The Company has been released from all obligations under the lease arrangement since March 31, 2014.    

25

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
14. LEASE ABANDONMENT AND TERMINATION (Continued)

A summary of the Company’s lease abandonment activity for the three months ended March 31, 2015 and 2014 is as follows (in thousands):
 
As of March 31,
 
2015
 
2014
Accrued lease abandonment costs, beginning of period
$
1,679

 
$
413

Costs incurred and charged to expense

 
3,571

Principal reductions
(129
)
 
(1,244
)
Accrued lease abandonment costs, end of period
$
1,550

 
$
2,740

Accrued lease abandonment costs liability:
 
 
 

Short-term
$
462

 
$
1,281

Long-term
1,088

 
1,459

Total
$
1,550

 
$
2,740

15. COMMITMENTS AND CONTINGENCIES
Operating Leases
The Company leases copiers, parking spaces, buildings, a warehouse and office space under operating lease and site license arrangements, some of which contain renewal options. Building, warehouse and office space leases range from 12 months to 74 months. Certain leases also include lease renewal options.
The following table summarizes future minimum operating lease payments for the remaining nine months of 2015 and the years thereafter (in thousands):
 
 
As of March 31, 2015
Periods Ending December 31,
 
 
2015-remaining
 
$
3,665

2016
 
4,591

2017
 
3,923

2018
 
3,344

2019
 
753

Thereafter
 
883

Total
 
$
17,159

Total expenses under operating leases were $1.4 million and $1.5 million for the three months ended March 31, 2015 and 2014, respectively. 
The Company accounts for its leases under the provisions of ASC topic 840, Accounting for Leases ("ASC 840"), and subsequent amendments, which require that leases be evaluated and classified as operating leases or capital leases for financial reporting purposes. Certain operating leases contain rent escalation clauses, which are recorded on a straight-line basis over the initial term of the lease with the difference between the rent paid and the straight-line rent recorded as either a deferred rent asset or liability depending on the calculation. Lease incentives received from landlords are recorded as deferred rent liabilities and are amortized on a straight-line basis over the lease term as a reduction to rent expense.
The deferred rent liability was $0.5 million and $0.5 million at March 31, 2015 and December 31, 2014, respectively. The deferred rent asset was $41,000 and $20,000 at March 31, 2015 and December 31, 2014, respectively. The deferred rent asset is classified in prepaid and other assets as all associated leases have less than one year remaining on their term.

26

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
15. COMMITMENTS AND CONTINGENCIES (Continued)


Litigation    
In June 2011, Rosetta Stone GmbH, a subsidiary of the Company, was served with a writ filed by Langenscheidt KG (“Langenscheidt”) in the District Court of Cologne, Germany alleging trademark infringement due to Rosetta Stone GmbH’s use of the color yellow on its packaging of its language-learning software and the advertising thereof in Germany. Langenscheidt sought relief in the form of monetary damages and injunctive relief; however there has not been a demand for a specific amount of monetary damages and there has been no specific damage amount awarded to Langenscheidt.  In January 2012, the District Court of Cologne ordered an injunction against specific uses of the color yellow made by Rosetta Stone GmbH in packaging, on its website and in television commercials and declared Rosetta Stone GmbH liable for damages, attorneys’ fees and costs to Langenscheidt. In its decision, the District Court of Cologne also ordered the destruction of Rosetta Stone GmbH’s product and packaging which utilized the color yellow and which was deemed to have infringed Langenscheidt’s trademark. The Court of Appeals in Cologne and the German Federal Supreme Court have affirmed the District Court's decision.  The Company has filed special complaints with the German Federal Supreme Court and the German Constitutional Court directed to constitutional issues in the German Federal Supreme Court’s decision.
In August 2011, Rosetta Stone GmbH commenced a separate proceeding for the cancellation of Langenscheidt’s German trademark registration of yellow as an abstract color mark. In June 2012, the German Patent and Trademark Office rendered a decision in the cancellation proceeding denying our request to cancel Langenscheidt’s German trademark registration. The German Federal Supreme Court has denied Rosetta Stone GmbH's further appeal but has not yet issued its written decision denying further appeal.
Rosetta Stone GmbH expects that damages will be awarded to Langenscheidt based on the finding of trademark infringement. However, at this point, the Company cannot predict the amount of damages which Langenscheidt will be awarded nor when any damages will be required to be paid. The Company has concluded that Rosetta Stone GmbH will be required to pay court costs and opposing counsel fees and Langenscheidt has filed a Motion for Attorneys’ Fees to which Rosetta Stone GmbH has objected. The Company has concluded that it will be required to pay court costs and opposing counsel fees and has recorded a liability of $0.3 million as of March 31, 2015. The Company will continue to incur legal fees and other costs in connection with the resolution of this case.
From time to time, the Company has been subject to various claims and legal actions in the ordinary course of its business. The Company is not currently involved in any legal proceeding the ultimate outcome of which, in its judgment based on information currently available, would have a material impact on its business, financial condition or results of operations.
16. SEGMENT INFORMATION
In March 2015, the Company announced a strategic reorganization and realignment of the business to accelerate and prioritize and reorganize the business around the Enterprise & Education segment. As a result of this shift, the Company reevaluated its segment structure. Prior to the strategy shift, the Company was managed in three operating segments - "Global Enterprise & Education", "North America Consumer", and "Rest of World Consumer". Following the strategy shift, the Company is managed in two operating segments - "Enterprise & Education" and "Consumer", whereby the current Consumer segment includes the prior North America Consumer and Rest of World Consumer segments. The Company's current operating segments also represent the Company's reportable segments. The Company will continue to evaluate its management reporting and will update its operating and reportable segments as appropriate.
The Company assesses profitability of each segment in terms of segment contribution. Segment contribution is the measure of profitability used by our Chief Operating Decision Maker ("CODM"). The CODM assesses profitability and performance of the Company on its current operating segments. 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 expenses, and bad debt expense. The Company does not allocate expenses beneficial to all segments, which include certain general and administrative expenses, facilities and communication expenses, purchasing expenses and manufacturing support and logistic expenses. These expenses are included in the unallocated expenses section of the table presented below. Revenue from transactions between the Company's operating segments is not material.
During the first quarter of 2015, the CODM was the Company's Chief Executive Officer ("CEO"). Effective April 1, 2015, the Company's CEO resigned and an Interim President and CEO was appointed. In connection with this change and the reorganization and realignment of the business to prioritize the Enterprise & Education segment, the Company is evaluating the role of the CODM, the measure of profitability to be used by the CODM and the level at which the measure of profitability is

27

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
16. SEGMENT INFORMATION (Continued)

reviewed by the CODM. Any changes to the CODM and conclusions around operating and reportable segments will be made on a prospective basis.
With the exception of goodwill, the Company does not identify or allocate its assets by operating segment. Consequently, the Company does not present assets or liabilities by operating segment.
Operating results by segment for the three months ended March 31, 2015 and 2014 were as follows (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2015
 
2014
Revenue:
 
 
 
 
Enterprise & Education
 
$
23,168

 
$
17,882

Consumer
 
35,274

 
42,883

Total revenue
 
$
58,442

 
$
60,765

Segment contribution:
 
 
 
 
Enterprise & Education
 
6,274

 
4,201

Consumer
 
9,106

 
12,055

Total segment contribution
 
$
15,380

 
$
16,256

Unallocated expenses, net:
 
 
 
 
Unallocated cost of sales
 
2,550

 
2,512

Unallocated sales and marketing
 
6,239

 
5,225

Unallocated research and development
 
8,972

 
8,773

Unallocated general and administrative
 
15,355

 
15,075

Unallocated non-operating expense/(income)
 
1,665

 
(175
)
Unallocated impairment
 
291

 
2,199

Unallocated lease abandonment expense
 

 
3,571

Total unallocated expenses, net
 
$
35,072

 
$
37,180

Loss before income taxes
 
$
(19,692
)
 
$
(20,924
)
Geographic Information
Revenue by major geographic region is based primarily upon the geographic location of the customers who purchase the Company's products. The geographic locations of distributors and resellers who purchase and resell the Company's products may be different from the geographic locations of end customers.
The information below summarizes revenue from customers by geographic area for the three months ended March 31, 2015 and 2014 (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2015
 
2014
United States
 
$
46,189

 
$
49,410

International
 
12,253

 
11,355

Total
 
$
58,442

 
$
60,765


28

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
16. SEGMENT INFORMATION (Continued)

The information below summarizes long-lived assets by geographic area as of March 31, 2015 and December 31, 2014 (in thousands):
 
 
March 31,
2015
 
December 31,
2014
United States
 
$
20,803

 
$
20,451

International
 
4,216

 
4,826

Total
 
$
25,019

 
$
25,277

Revenue by Type
The Company earns revenue from the sale of language-learning, literacy and brain fitness products and services. The information below summarizes revenue by type for the three months ended March 31, 2015 and 2014 (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2015
 
2014
Language learning
 
$
53,165

 
$
59,112

Literacy
 
4,170

 
1,411

Brain fitness
 
1,107

 
242

Total
 
$
58,442

 
$
60,765

17. SUBSEQUENT EVENTS
Effective May 1, 2015, the Company executed the Second Amendment to its $25 million revolving credit Loan and Security Agreement with Silicon Valley Bank to further amend certain financial covenants.


29


Item 2.    Management's Discussion and Analysis of Financial Condition and Results of Operations
This Quarterly Report on Form 10-Q (this “Report”) and other statements or presentations made from time to time by the Company contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which can be identified by the fact that they do not relate strictly to historical or current facts, often include words such as "believes," "expects," "anticipates," "estimates," "intends," "plans," "seeks" or words of similar meaning, or future-looking or conditional verbs, such as "will," "should," "could," "may," "might," "aims," "intends," or "projects.” However, the absence of these words or similar expressions does not mean that a statement is not forward-looking.  These statements may relate to:  our revised business strategy; guidance or projections related to bookings, Adjusted EBITDA, and other measures of future economic performance; the contributions and performance of our businesses including acquired businesses and international operations; projections for future capital expenditures; and other guidance, projections, plans, objectives, and related estimates and assumptions.  A forward-looking statement is neither a prediction nor a guarantee of future events or circumstances, and those future events or circumstances might not occur.  Management believes that these forward-looking statements are reasonable as and when made.  However, caution should be taken not to place undue reliance on any such forward-looking statements because such statements speak only as of the date when made.  We expressly disclaim any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.  In addition, forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our present guidance, expectations or projections.  These risks and uncertainties include, but are not limited to, those described below, those discussed in the sections titled "Risk Factors" in Part II, Item 1A of this Report and those described from time to time in our future reports filed with the Securities and Exchange Commission. This section should be read together with our unaudited consolidated financial statements and related notes set forth elsewhere in this Report and should be read together with our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 16, 2015. 
Management uses bookings to evaluate the overall health of the business and evaluate performance. Bookings are a non-GAAP financial measure that represents executed sales contracts received that are either recorded immediately as revenue or as deferred revenue. Bookings are calculated in total and at the operating segment level as revenue plus the change in deferred revenue. Management believes that the bookings metric provides useful information to investors regarding certain financial and business trends relating to our financial condition and results of operations.
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, reading and brain fitness solutions are used by thousands of schools, businesses, government organizations and millions of individuals around the world.
Rosetta Stone Inc. was incorporated in Delaware in 2005. 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 web-based software subscriptions, digital downloads, mobile applications, and perpetual CD packages. Rosetta Stone has continued to invest 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. These acquisitions have enabled the Company to meet the changing needs of learners around the world. The Company is managed in two operating segments—Enterprise & Education and Consumer. The Enterprise & Education segment derives revenue from sales to educational institutions, government agencies and corporations worldwide. The Consumer segment derives revenue from sales to individuals and retail partners.
Over the last two years, we have expanded the breadth of our language and literacy products with the acquisitions of Tell Me More and Lexia. These acquisitions have reinforced our belief that the Enterprise & Education segment is our largest opportunity for long-term value creation. The customers in these markets have demands that recur each year, creating a more predictable revenue opportunity. This demand profile also fits well with our suite of products and the well-known Rosetta Stone brand. We also believe the opportunity to deliver English language learning is growing around the globe.
As a result, we recently communicated a strategic reorganization and realignment of our business to accelerate and prioritize our focus on satisfying the needs of more serious Corporate and K-12 learners, and emphasize those who need to speak and read English. This focus carries over to the Consumer segment to prioritize more serious learners, rather than trying to address the entire consumer marketplace. To position the organization for success, we have begun and will continue to focus on the following four priorities:
1.
Reorganize our business around our Enterprise & Education segment and accelerate the growth and penetration in language and literacy markets;
2.
Focus our product investment on building effective, personalized English learning experiences that deliver clear and measurable outcomes and expand our literacy products to target grade levels;

30


3.
Right-size the entire cost base of the Company, with the first steps to
optimize our media spend and other marketing costs in Consumer sales and marketing;
ration our Consumer investment; and,
reduce our general and administrative costs.
4.
Cut back on the number of new business initiatives we take on - particularly in Consumer - to improve focus and enhance efficacy.
In pursuing these priorities, we plan to grow the Enterprise & Education segment by focusing the majority of our resources and assets on providing a comprehensive language learning experience focused on more serious language learners while at the same time accelerating the migration of our Consumer segment business to digital as well as reducing the number of marketing and promotional campaigns aimed at the casual learner, relying less on promotional pricing to generate consumer sales, reducing the number of retailers that sell our products, and streamlining operations with a clear focus to support the Enterprise & Education segment.
To carry out the strategic reorganization and realignment of the business, we initiated our plan (the "2015 Restructuring Plan") to begin reductions to consumer sales and marketing, consumer product investment, and general and administrative costs. The Company expects to realize annualized cost savings of approximately $50 million in connection with the strategic reorganization and realignment of the business, of which the 2015 Restructuring Plan is an important part. These costs savings will mitigate expected declines in Consumer segment bookings. See Note 2 "Summary of Significant Accounting Policies" and Note 13 "Restructuring" of Part 1 - Item 1, Financial Statements for additional information about these strategic undertakings. In addition, Stephen M. Swad, who served as our President and Chief Executive Officer throughout 2014, resigned this position effective April 1, 2015. The Board of Directors appointed A. John Hass to serve as Interim President and Chief Executive Officer, also effective April 1, 2015, while the Company engages in a search for a chief executive officer.
As a result of the actions described above, as of March 31, 2015, we currently have two operating segments, Enterprise & Education and Consumer, rather than three operating segments (Global Enterprise & Education, North America Consumer, and Rest of World Consumer). We discuss the profitability of each segment in terms of segment contribution. Segment contribution is the measure of profitability used by our Chief Operating Decision Maker ("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. Enterprise & Education segment contribution increased to $6.3 million for the three months ended March 31, 2015 as compared to $4.2 million for the three months ended March 31, 2014, primarily due to the increase in Enterprise & Education revenue driven by an increase in literacy revenue of $2.8 million and increases of $0.9 million and $1.3 million in our corporate and education channels, respectively. Consumer segment contribution decreased from $12.1 million for the three months ended March 31, 2014 to $9.1 million for the three months ended March 31, 2015. The decrease in Consumer segment contribution is primarily due to a decrease in consumer revenue, which was only partially offset by a decrease in media spend and other cost reduction initiatives to align Consumer segment spending with our strategic focus on the Enterprise & Education segment.
Over the last few years, our consumer strategy has been to shift more and more of our consumer business to online subscriptions, digital downloads and mobile apps and away from perpetual CD packages. We believe that these online subscription formats provide customers with an overall better experience and the flexibility to use our products on multiple platforms (i.e., tablets and mobile phones), and is a more economical and relevant way for us to deliver our products to customers. One challenge to encouraging customers to enter into or renew a subscription arrangement is that usage of our product varies greatly, ranging from customers that purchase but do not have any usage to customers with high usage. The majority of purchasers tend towards the lower end of that spectrum, with most usage coming in the first few months after purchase and declining over time - similar to a gym membership.
For additional information regarding our segments, see Note 16 "Segment Information" of Part 1 - Item 1, Financial Statements. For additional information regarding fluctuations in segment revenue, see Results of Operations, below. Prior periods have been reclassified to reflect our current operating segments presentation and definition of segment contribution.
Components of Our Statement of Operations
Revenue
We derive revenue from sales of language-learning, literacy, and brain fitness solutions. Revenue is presented as product revenue or subscription and service revenue in our consolidated financial statements. Product revenue primarily consists of revenue from our perpetual language-learning product software, our audio practice products, and certain mobile applications. Our audio practice products are often combined with our language-learning software and sold as a solution. Subscription and service revenue consist of sales from web-based software subscriptions, online services, professional services, and certain mobile applications. Our online services are typically sold in short-term service periods and include dedicated online

31


conversational coaching services and access to online communities of language learners. Our professional services include training and implementation services.
In the consumer market, our perpetual product software is often bundled with our short-term online conversational coaching and online community services and sold as a package. Approximately $25 to $39 in revenue per unit is derived from these short-term online services. As a result, we typically defer 10%-35% of the revenue of each of these bundled sales to be recognized over the term of the service period. The content of our perpetual product software and our web-based language-learning subscription offerings are the same. We offer our customers the ability to choose which format they prefer without differentiating the learning experience.
We sell our solutions directly and indirectly to individuals, educational institutions, corporations, and governmental 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. We sell to enterprise and education organizations primarily through our direct enterprise and education sales force as well as our network of resellers and organizations who typically gain access to our solutions under a web-based subscription service. 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, 2014 accounted for 29% of our annual revenue in 2014. 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 web-based subscription services and online language-learning services, 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.
Operating Expenses
We classify our operating expenses into the following categories: sales and marketing, research and development, general and administrative, impairment, and lease abandonment and termination.
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. Included within our operating expenses are restructuring costs that consist primarily of employee severance and related benefit costs, contract termination costs, and other related costs associated with our restructuring activities associated with our planned and strategic shift in business focus. When certain events occur, we also recognize operating expenses related to asset impairment and operating lease terminations.
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, 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. In connection with our new strategy of focusing on the Enterprise & Education segment, we intend to reduce the number of marketing and promotional campaigns that we run, focusing more on brand messaging that withstands the test of time, and less on promotional pricing.
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 offering portfolio through the addition of new content and new paid and complementary products and services to our language-learning, literacy, and brain fitness solutions. We expect our investment in research and development expenses to increase in future years as we fund product initiatives that we expect to provide us with significant benefits in the future.

32


General and Administrative.    General and administrative expenses consist primarily of shared services, such as 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. We expect our general and administrative expenses to decline as we take steps to reduce our non-Enterprise & Education headcount as well as other cost reductions.
Impairment.   Impairment expenses consist primarily of goodwill impairment and impairment expense related to the abandonment of previously capitalized internal-use software projects.
Lease Abandonment and Termination.   Lease abandonment and termination expenses include the recognition of costs associated with the termination or abandonment of certain of our office operating leases, such as early termination fees and expected lease termination costs.
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 and our revolving credit facility. 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 three months ended March 31, 2015, we incurred an income tax expense of $0.2 million, despite incurring losses before taxes of $19.7 million resulting in worldwide effective tax rate of (0.98)%. The tax rate resulted from tax expense related to current year income of operations in Germany, foreign withholding taxes, and the tax impact of amortization of indefinite lived intangibles. This was offset by tax benefits related to current year losses in the U.K. and Canada.
For the year ended December 31, 2014, the Company recorded income tax benefit of $6.5 million primarily attributable to losses before tax of $80.2 million resulting in worldwide effective tax rate of 8.1%. The tax rate resulted from tax benefits related to the tax impact of the goodwill impairment charges taken in the first and fourth quarters of 2014 and tax benefits related to current year losses in Canada and France. The tax benefits were only partially offset by tax expense related to current year income of operations in Germany and the U.K., foreign withholding taxes, and the tax impact of amortization of indefinite lived intangible assets.
Critical Accounting Policies and Estimates
In presenting our financial statements in conformity with GAAP, 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.
We believe that the following critical accounting policies involve our more significant judgments, assumptions and estimates and, therefore, could have the greatest potential impact on our consolidated financial statements:
Revenue Recognition
Stock-based Compensation
Restructuring Costs
Income Taxes
Allowance for Doubtful Accounts Receivable
Sales Return Reserve
Goodwill
Other Intangible Assets
For further information on our critical and other significant accounting policies, see our Annual Report on Form 10-K filed with the SEC on March 16, 2015. There have been no significant changes in such critical accounting policies and estimates since those disclosed in our most recent Annual Report on Form 10-K, other than the addition of accounting policies

33


related to Restructuring Costs, as disclosed in Note 2, "Summary of Significant Accounting Policies" of Part 1 - Item 1, Financial Statements and the changes described in the following section.
Reporting Units
Prior to 2013, the Company's reporting units were the same as its operating segments. In 2013 and 2014 the Company reevaluated its reporting units as a result of the Company's business acquisitions and diversification into additional education technology spaces. In the first quarter of 2015, the Company again reevaluated its reporting units following the strategic shift in business. Accordingly, the North America Consumer Language and the Rest of World Consumer Language reporting units (both of which had zero remaining goodwill as of the beginning of 2015 due to prior year impairments) were combined into the Consumer Language reporting unit.
As of March 31, 2015, the Company's reporting units are: Consumer Language, Consumer Fit Brains, Enterprise & Education Language, and Enterprise & Education Literacy. The Consumer Language and Consumer Fit Brains reporting units are components of the Consumer operating segment. The Enterprise & Education Language and Enterprise & Education Literacy reporting units are components of the Enterprise & Education operating segment.

34


Results of Operations
The following table sets forth our consolidated statement of operations for the periods indicated (in thousands, except percentages):
 
 
Three Months Ended March 31,
 
2015 Versus 2014
 
 
2015
 
2014
 
Change
 
% Change
Revenue:
 
 
 
 
 
 
 
 
Product
 
$
19,974

 
$
32,371

 
$
(12,397
)
 
(38.3
)%
Subscription and service
 
38,468

 
28,394

 
10,074

 
35.5
 %
Total revenue
 
58,442

 
60,765

 
(2,323
)
 
(3.8
)%
Cost of revenue:
 
 
 
 
 
 
 
 
Cost of product revenue
 
5,637

 
7,824

 
(2,187
)
 
(28.0
)%
Cost of subscription and service revenue
 
5,665

 
4,347

 
1,318

 
30.3
 %
Total cost of revenue
 
11,302

 
12,171

 
(869
)
 
(7.1
)%
Gross profit
 
47,140

 
48,594

 
(1,454
)
 
(3.0
)%
Operating expenses:
 
 
 
 
 
 
 
 
Sales and marketing
 
40,150

 
39,096

 
1,054

 
2.7
 %
Research and development
 
8,972

 
8,773

 
199

 
2.3
 %
General and administrative
 
15,754

 
16,054

 
(300
)
 
(1.9
)%
Impairment
 
291

 
2,199

 
(1,908
)
 
(86.8
)%
Lease abandonment and termination
 

 
3,571

 
(3,571
)
 
(100.0
)%
Total operating expenses
 
65,167

 
69,693

 
(4,526
)
 
(6.5
)%
Loss from operations
 
(18,027
)
 
(21,099
)
 
3,072

 
(14.6
)%
Other income and (expense):
 
 
 
 
 
 
 
 
Interest income
 
4

 
5

 
(1
)
 
(20.0
)%
Interest expense
 
(88
)
 
(56
)
 
(32
)
 
57.1
 %
Other income and (expense)
 
(1,581
)
 
226

 
(1,807
)
 
(799.6
)%
Total other income and (expense)
 
(1,665
)
 
175

 
(1,840
)
 
(1,051.4
)%
Loss before income taxes
 
(19,692
)
 
(20,924
)
 
1,232

 
(5.9
)%
Income tax expense (benefit)
 
192

 
(683
)
 
875

 
(128.1
)%
Net loss
 
$
(19,884
)
 
$
(20,241
)
 
$
357

 
(1.8
)%
Comparison of the three months ended March 31, 2015 and the three months ended March 31, 2014
Our revenue decreased to $58.4 million for the three months March 31, 2015 from $60.8 million for the three months ended March 31, 2014. The change in revenue is due to an increase in Enterprise & Education revenue of $5.3 million, which was more than offset by a decrease in Consumer revenue of $7.6 million. Total consolidated bookings decreased to $50.5 million for the three months ended March 31, 2015 from $61.2 million for the three months ended March 31, 2014. The decrease was due to a $7.4 million decrease in Consumer bookings and a decrease in Enterprise & Education bookings of $3.3 million, compared to the prior year.
We reported an operating loss of $18.0 million for the three months ended March 31, 2015 compared to an operating loss of $21.1 million for the three months ended March 31, 2014. Operating expenses decreased $4.5 million, which included a $1.9 million reduction in goodwill and other impairment charges and a $3.6 million reduction in lease abandonment and termination expenses. Excluding the impairment and lease-related costs, operating expenses increased $1.0 million, comprised of increases of $1.1 million in sales and marketing expenses and $0.2 million in research and development expenses, partially offset by a decrease of $0.3 million in general and administrative expenses. The increase in operating expenses, excluding the impairment and lease-related costs, reflects the up-front restructuring costs incurred and late timing of actions as a result of our shift in strategy. The overall decrease in operating expenses was partially offset by a decrease in gross profit of $1.5 million, driven by a $2.3 million decrease in revenue and a $0.9 million decrease in cost of revenue.

35


The following table sets forth revenue for our two operating segments for the three months ended March 31, 2015 and 2014 (in thousands, except percentages):
 
 
Three Months Ended March 31,
 
2015 Versus 2014
 
 
2015
 
 
 
2014
 
 
 
Change
 
% Change
Enterprise & Education
 
23,168

 
39.6
%
 
17,882

 
29.4
%
 
$
5,286

 
29.6
 %
Consumer
 
35,274

 
60.4
%
 
42,883

 
70.6
%
 
$
(7,609
)
 
(17.7
)%
Total Revenue
 
$
58,442

 
100.0
%
 
$
60,765

 
100.0
%
 
$
(2,323
)
 
(3.8
)%
Enterprise & Education Segment
Total Enterprise & Education revenue increased $5.3 million, or 30%, from the three months ended March 31, 2014 to the three months ended March 31, 2015. Enterprise & Education literacy revenue increased $2.8 million. Enterprise & Education language revenue increased $0.9 million and $1.3 million in our corporate and education channels, respectively. Total Enterprise & Education bookings decreased $3.3 million to $15.0 million for the three months ended March 31, 2015 from $18.3 million for the three months ended March 31, 2014. Enterprise & Education literacy bookings increased $0.3 million. Enterprise & Education language bookings decreased $2.5 million and $1.2 million in our education and corporate channels, respectively due to weaker than expected results in Europe, Brazil and Asia (excluding China). The year over year change in Enterprise & Education revenue increased despite a decrease in Enterprise & Education bookings due to the revenue recognition of subscription service contracts recorded as deferred revenue in prior periods. Due to purchase accounting, deferred revenue associated with Lexia and Tell Me More was recorded at fair value, which is lower than the book value, and resulted in lower Q1 2014 revenue. As a result, we expect year over year revenues to become more comparable as we lap the purchase accounting impact, which will result in lower revenue growth rates than what we experienced in the first quarter of 2015. Our Enterprise & Education business is seasonal with most of our bookings coming in the second and third quarters.
Consumer Segment
Consumer revenue decreased $7.6 million, or 18%, from the three months ended March 31, 2014 to the three months ended March 31, 2015. This decrease was due to reductions in revenue from our direct-to-consumer and retail sales channels of $6.9 million and $1.7 million, respectively, partially offset by increases of $0.9 million and $0.3 million related to Fit Brains and international e-commerce sales, respectively. Consumer bookings decreased $7.4 million to $35.5 million for the three months ended March 31, 2015 from $43.0 million for the three months ended March 31, 2014. This decrease was due to reductions in bookings from our direct-to-consumer, Fit Brains, and retail sales channels of $7.0 million, $0.4 million, and $0.1 million, respectively. These declines reflect the decision to significantly curtail promotional pricing under our strategic transformation. In recent quarters, we focused on driving customers to purchase through our direct-to-consumer channel, particularly through our website, by implementing more aggressive discounting and promotional activity to combat the introduction of lower priced competitor products. In connection with our shift in strategy to focus on the serious learner, we expect to be more disciplined with pricing, relying much less on discounting, which may negatively impact our consumer revenue and bookings.
Consumer Business Metrics
Management uses the following key business metrics to measure the success of sales of our legacy Rosetta Stone language-learning solutions in our Consumer segment. We anticipate our metrics will evolve as a result of our shift in strategy. However, management does not currently use any comparable metrics to measure success of our Enterprise & Education segment, nor does management currently have a business metric to measure success of our Rosetta Stone Fit Brains and Rosetta Stone Kids offerings. These business metrics do not include product software units, revenues, or learners gained from acquisitions.
Product software units.  A unit is a perpetual software license sold as either tangible packaged software or as a digital download.

Average revenue per product software unit ("ARPU").  Consumer revenue derived from product software units divided by the number of product software units sold in the same period. Revenue from product software includes consumer language-learning revenue associated with perpetual product software licenses in addition to service revenue associated with short-term online services that are bundled with our product software units. Approximately $25 to $39 in revenue per product software unit is derived from service revenue associated with this short-term online service.


36


Paid online learners.  As of the end of a specified period, the number of paid, active consumer language-learners derived from the sale of our web-based software subscription and purchasers of our product software who subsequently purchase renewals of their short-term online services.

Average monthly revenue per paid online learner.  Revenue 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 three months ended March 31, 2015 and 2014 (revenue stated in thousands):
 
 
Three Months Ended March 31,
 
 
2015
 
2014
Product software revenue
 
$
24,686

 
$
36,225

Paid online learner revenue
 
8,662

 
6,281

Total consumer revenue*
 
$
33,348

 
$
42,506

 
 
 
 
 
Product software units
 
134,031

 
132,623

Total paid online learners*
 
189,248

 
100,430

 
 
 
 
 
Average revenue per product software unit (ARPU)
 
$
184

 
$
273

Average monthly revenue per online learner*
 
$
16

 
$
22

* The unit and online learner metrics relate to the results for our language-learning offerings within the Consumer segment and do not include revenue and learners from Rosetta Stone Fit Brains, Rosetta Stone Kids, mobile applications and other offerings gained through acquisitions.
Product software revenue includes consumer sales of our Consumer language-learning product software units. We anticipate the mix of product software units will shift from our traditional packaged product to digital downloads and web-based software subscriptions in future periods.
Worldwide consumer revenue from product software decreased $11.5 million from the three months ended March 31, 2014 to the three months ended March 31, 2015, driven by a 33% decrease in the average revenue per unit due to lower promotional pricing, slightly tempered by a 1% increase in the number of units sold, compared to the prior year period.  The slight increase in the number of units sold was due to 60% increase in units sold through retailers, offset by a 17% decrease in units sold direct to consumers. The selling price to our retail partners is lower than the selling price to customers of our direct to consumer channel.
Worldwide ARPU decreased $89, or 33%, from $273 for the three months ended March 31, 2014 to $184 for the three months ended March 31, 2015. The decline in ARPU was primarily due to more extensive promotional activity and deeper discounting year-over-year. The decrease in ARPU was also related to a shift in channel mix from direct to consumer to retail on a year-over-year basis, as described above. In addition, the amount of revenue per unit deferred increased from $25 to $39 in November 2014 such that a higher proportion of sales were deferred in the first quarter of 2015 than the year ago period. We expect to rely less on discounting practices as we focus our consumer demographic on the serious learners.
Revenue from paid online learners increased $2.4 million from the three months ended March 31, 2014 to the three months ended March 31, 2015, driven by an increase in the amount of revenue allocated to online service revenue due to the increase in the renewal price of the online portion of our language learning software bundle from $25 to $39 in late 2014. The increase was also attributable to the migration of the consumer business to subscriptions.
Revenue by Product Revenue and Subscription and Service Revenue
We categorize and report our revenue in two categories—product revenue and subscription and service revenue. Product revenue includes revenue allocated to our perpetual language-learning product software, revenue from the sale of audio practice products, and sales of certain mobile applications. Subscription and service revenue includes web-based software subscriptions, online services for our conversational coaching and language-learning community access, as well as revenue from professional

37


services. Subscription and service revenue are typically deferred at the time of sale and then recognized ratably over the subscription or service period. We bundle our perpetual product software with short-term online services. As a result, we typically defer 10%-35% of the revenue of each of these bundled sales. We recognize the deferred revenue over the term of the service period.
The following table sets forth revenue for products and subscription and services for the three months ended March 31, 2015 and 2014 (in thousands, except percentages):
 
 
Three Months Ended March 31,
 
 
 
2015 Versus 2014
 
 
2015
 
 
 
2014
 
 
 
Change
 
% Change
Product
 
$
19,974

 
34.2
%
 
$
32,371

 
53.3
%
 
$
(12,397
)
 
(38.3
)%
Subscription and service
 
38,468

 
65.8
%
 
28,394

 
46.7
%
 
10,074

 
35.5
 %
Total revenue
 
$
58,442

 
100.0
%
 
$
60,765

 
100.0
%
 
$
(2,323
)
 
(3.8
)%
Product Revenue
Product revenue decreased $12.4 million, or 38%, to $20.0 million during the three months ended March 31, 2015 from $32.4 million during the three months ended March 31, 2014. The drivers of the decrease in product revenue were decreases of $10.6 million and $1.3 million in the direct-to-consumer and retail sales channels, respectively. Product revenue also decreased due to the decrease in the average sale price of our bundled language-learning software products coupled with the increase in the revenue amount allocated and deferred to online service revenue due to the change in VSOE associated with this bundled service from $25 to $39 in late 2014. We expect a shift away from product revenue as we carry out our strategy to accelerate the migration of our consumer business to digital.
Subscription and Service Revenue
Subscription and service revenue increased $10.1 million, or 35%, to $38.5 million for the three months ended March 31, 2015 from $28.4 million for the three months ended March 31, 2014. The increase in subscription and service revenue was primarily due to increases of $4.2 million and $1.0 million in education and corporate service sales, respectively, within the Enterprise & Education segment and increases of $3.7 million and $0.9 million in direct-to-consumer and Fit Brains service sales, respectively, within the Consumer segment. Subscription and service revenue also increased due to the increase in the amount allocated to online service revenue due to the change in VSOE associated with the bundled service from $25 to $39 in late 2014 coupled with recent historical increases in unit volume. Our Q1 2014 subscription and service revenue was lower due to the write-down effects of purchase accounting on the pre-acquisition deferred revenue balances associated with Lexia and Tell Me More.
Cost of Product Revenue and Subscription and Service Revenue and Gross Profit
The following table sets forth cost of product revenue and subscription and service revenue, as well as gross profit for the three months ended March 31, 2015 and 2014 (in thousands, except percentages):
 
 
Three Months Ended March 31,
 
2015 Versus 2014
 
 
2015
 
2014
 
Change
 
% Change
Revenue:
 
 
 
 
 
 
 
 
Product
 
$
19,974

 
$
32,371

 
$
(12,397
)
 
(38.3
)%
Subscription and service
 
38,468

 
28,394

 
10,074

 
35.5
 %
Total revenue
 
58,442

 
60,765

 
(2,323
)
 
(3.8
)%
Cost of revenue:
 
 
 
 
 
 
 
 
Cost of product revenue
 
5,637