Attached files

file filename
EX-10.1 - EXHIBIT 10.1 - ROSETTA STONE INCa5thamendsvbcreditagmt.htm
EX-31.1 - EXHIBIT 31.1 - ROSETTA STONE INCa033116exhibit311.htm
EX-32 - EXHIBIT 32 - ROSETTA STONE INCa033116exhibit32.htm
EX-31.2 - EXHIBIT 31.2 - ROSETTA STONE INCa033116exhibit312.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, 2016
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 29, 2016, there were 21,919,136 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,
2016
 
December 31,
2015
Assets
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
42,995

 
$
47,782

Restricted cash
 
39

 
80

Accounts receivable (net of allowance for doubtful accounts of $1,241 and $1,196, at March 31, 2016 and December 31, 2015, respectively)
 
29,803

 
47,327

Inventory, net
 
7,229

 
7,333

Deferred sales commissions
 
12,368

 
13,526

Prepaid expenses and other current assets
 
5,004

 
3,612

Total current assets
 
97,438

 
119,660

Deferred sales commissions
 
5,023

 
5,614

Property and equipment, net
 
23,269

 
22,532

Goodwill
 
50,843

 
50,280

Intangible assets, net
 
27,168

 
28,244

Other assets
 
2,130

 
2,213

Total assets
 
$
205,871

 
$
228,543

Liabilities and stockholders' equity
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable
 
$
11,364

 
$
10,778

Accrued compensation
 
10,575

 
8,201

Income tax payable
 
464

 
121

Obligations under capital lease
 
546

 
521

Other current liabilities
 
27,400

 
35,318

Deferred revenue
 
99,279

 
106,868

Total current liabilities
 
149,628

 
161,807

Deferred revenue
 
32,978

 
35,880

Deferred income taxes
 
5,178

 
4,998

Obligations under capital lease
 
2,483

 
2,622

Other long-term liabilities
 
728

 
826

Total liabilities
 
190,995

 
206,133

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, 2016 and December 31, 2015, respectively
 

 

Non-designated common stock, $0.00005 par value, 190,000 and 190,000 shares authorized, 23,309 and 23,150 shares issued and 22,309 and 22,150 shares outstanding at March 31, 2016 and December 31, 2015, respectively
 
2

 
2

Additional paid-in capital
 
186,313

 
185,863

Accumulated loss
 
(157,301
)
 
(149,794
)
Accumulated other comprehensive loss
 
(2,703
)
 
(2,226
)
Treasury stock, at cost, 1,000 and 1,000 shares at March 31, 2016 and December 31, 2015, respectively
 
(11,435
)
 
(11,435
)
Total stockholders' equity
 
14,876

 
22,410

Total liabilities and stockholders' equity
 
$
205,871

 
$
228,543

   
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,
 
 
2016
 
2015
Revenue:
 
 
 
 
Product
 
$
10,031

 
$
19,974

Subscription and service
 
37,971

 
38,468

Total revenue
 
48,002

 
58,442

Cost of revenue:
 
 
 
 
Cost of product revenue
 
2,645

 
5,637

Cost of subscription and service revenue
 
5,403

 
5,665

Total cost of revenue
 
8,048

 
11,302

Gross profit
 
39,954

 
47,140

Operating expenses:
 
 
 
 
Sales and marketing
 
30,793

 
40,150

Research and development
 
6,571

 
8,972

General and administrative
 
10,777

 
15,754

Impairment
 

 
291

Total operating expenses
 
48,141

 
65,167

Loss from operations
 
(8,187
)
 
(18,027
)
Other income and (expense):
 
 
 
 
Interest income
 
13

 
4

Interest expense
 
(112
)
 
(88
)
Other income and (expense)
 
1,228

 
(1,581
)
Total other income and (expense)
 
1,129

 
(1,665
)
Loss before income taxes
 
(7,058
)
 
(19,692
)
Income tax expense
 
449

 
192

Net loss
 
$
(7,507
)
 
$
(19,884
)
Loss per share:
 
 
 
 
Basic
 
$
(0.34
)
 
$
(0.95
)
Diluted
 
$
(0.34
)
 
$
(0.95
)
Common shares and equivalents outstanding:
 
 
 
 
Basic weighted average shares
 
21,867

 
21,018

Diluted weighted average shares
 
21,867

 
21,018

   
See accompanying notes to consolidated financial statements

4


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

 
 
Three Months Ended 
 March 31,
 
 
2016
 
2015
Net loss
 
$
(7,507
)
 
$
(19,884
)
Other comprehensive loss, net of tax:
 
 
 
 
Foreign currency translation loss
 
(477
)
 
(1,147
)
Other comprehensive loss
 
(477
)
 
(1,147
)
Comprehensive loss
 
$
(7,984
)
 
$
(21,031
)
   See accompanying notes to consolidated financial statements




5


ROSETTA STONE INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
 
Three Months Ended 
 March 31,
 
 
2016
 
2015
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
 
Net loss
 
$
(7,507
)
 
$
(19,884
)
Adjustments to reconcile net loss to cash used in operating activities:
 
 
 
 
Stock-based compensation expense
 
421

 
1,287

(Gain) loss on foreign currency transactions
 
(1,525
)
 
1,372

Bad debt expense
 
191

 
410

Depreciation and amortization
 
3,408

 
3,350

Deferred income tax expense
 
172

 
295

Gain on disposal of equipment
 

 
(1
)
Amortization of deferred financing fees
 
62

 
32

Loss on impairment
 

 
291

Loss from equity method investments
 
27

 

Net change in:
 
 
 
 
Restricted cash
 
41

 
17

Accounts receivable
 
17,555

 
24,546

Inventory
 
116

 
(1,957
)
Deferred sales commissions
 
1,783

 
59

Prepaid expenses and other current assets
 
(1,331
)
 
(1,322
)
Income tax receivable
 
337

 
(444
)
Other assets
 
88

 
(314
)
Accounts payable
 
569

 
(4,401
)
Accrued compensation
 
2,310

 
(1,146
)
Other current liabilities
 
(8,189
)
 
(9,041
)
Other long-term liabilities
 
(99
)
 
(225
)
Deferred revenue
 
(10,975
)
 
(6,231
)
Net cash used in operating activities
 
(2,546
)
 
(13,307
)
CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
 
Purchases of property and equipment
 
(2,586
)
 
(2,382
)
Acquisitions, net of cash acquired
 

 
(1,688
)
Net cash used in investing activities
 
(2,586
)
 
(4,070
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
 
Proceeds from the exercise of stock options
 
29

 
37

Payment of financing fees
 
(100
)
 
(27
)
Payments under capital lease obligations
 
(244
)
 
(282
)
Net cash used in financing activities
 
(315
)
 
(272
)
Decrease in cash and cash equivalents
 
(5,447
)
 
(17,649
)
Effect of exchange rate changes in cash and cash equivalents
 
660

 
(1,084
)
Net decrease in cash and cash equivalents
 
(4,787
)
 
(18,733
)
Cash and cash equivalents—beginning of period
 
47,782

 
64,657

Cash and cash equivalents—end of period
 
$
42,995

 
$
45,924

SUPPLEMENTAL CASH FLOW DISCLOSURE:
 
 
 
 
Cash paid (received) during the periods for:
 
 
 
 
Interest
 
$
50

 
$
57

Income taxes, net of refunds
 
$
(61
)
 
$
463

Noncash financing and investing activities:
 
 
 
 
Accrued liability for purchase of property and equipment
 
$
357

 
$
732

Equipment acquired under capital lease
 
$
27

 
$

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 select third party retailers and distributors. 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 14, 2016, the Company announced that it intends to exit the direct sales presence in almost all of its non-U.S. and non-northern European geographies related to the distribution of the Enterprise & Education Language offerings (the "2016 Restructuring Plan"). Where appropriate, the Company seeks to operate through partners in the geographies being exited. The Company also looks to initiate processes to close the software development operations in France and China. These actions are additive to the plan announced on March 11, 2015 (the "2015 Restructuring Plan") to accelerate and prioritize its focus on satisfying the needs of more passionate Corporate and K-12 learners, and emphasizing those who need to speak and read English. 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 and its wholly owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. 
The equity method is used to account for investments in entities if the investment provides the Company with the ability to exercise significant influence over operating and financial policies of the investee. The Company determines its level of influence over an equity method investment by considering key factors such as ownership interest, representation on the investee's governing body, participation in policy-making decisions, and technological dependencies. The Company's proportionate share of the net income or loss of any equity method investments is reported in "Other income and (expense)" and included in the net loss on the consolidated statement of operations. The carrying value of any equity method investment is reported in "Other assets" on the consolidated balance sheets.
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 14, 2016. The March 31, 2016 consolidated balance sheet included herein includes account balances as of December 31, 2015 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, 2016 and December 31, 2015, the Company’s results of operations for the three months ended March 31, 2016 and 2015 and its cash flows for the three months ended March 31, 2016 and 2015 have been made. The results for the three months ended March 31, 2016 are not necessarily indicative of the results to be expected for the year ending December 31, 2016. All references to March 31, 2016 or to the three months ended March 31, 2016 and 2015 in the notes to the consolidated financial statements are unaudited.

7

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

Use of Estimates
The preparation of financial statements in accordance with GAAP requires management to make certain estimates and assumptions. The amounts reported in the consolidated financial statements include significant estimates and assumptions that have been made, including, but not limited to, those related to revenue recognition, allowance for doubtful accounts, estimated sales returns and reserves, stock-based compensation, restructuring costs, fair value of intangibles and goodwill, disclosure of contingent assets and liabilities, disclosure of contingent litigation, and allowance for valuation of deferred tax assets. The Company bases its estimates and assumptions on historical experience and on various other judgments that are believed to be reasonable under the circumstances. The Company continuously evaluates its estimates and assumptions. Actual results may differ from these estimates and assumptions.
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 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 online services, the Company allocates the total arrangement consideration to its deliverables based on the existence of 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 online service, which is considered an undelivered software-related element. The online service includes access to conversational coaching services. Because the Company only sells the 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 the perpetual product. Where VSOE of the undelivered online services can be established, arrangement consideration is allocated using the residual method. The Company determines VSOE by reference to the range of comparable stand-alone renewal sales of the 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. Where VSOE of the undelivered online services cannot be established, revenue is deferred and recognized commensurate with the delivery of the online services.
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 Language and Literacy 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 Language and Literacy 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

8

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

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 an online service where customers are allowed to begin their 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 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
As part of the 2016 Restructuring Plan and the 2015 Restructuring Plan, 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 these plans, 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

9

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

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.
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, 2016. 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.

10

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

Divestitures
The Company deconsolidates divested subsidiaries when there is a loss of control or when appropriate when evaluated under the variable interest entity model. The Company recognizes a gain or loss at divestiture equal to the difference between the fair value of any consideration received and the carrying amount of the former subsidiary’s assets and liabilities. Any resulting gain or loss is reported in "Other income and (expense)" on the consolidated statement of operations.
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.
The Company estimates the expected term of options using a combination of peer company information and the simplified method for estimating the expected term. The Company uses its own historical stock price data to estimate its forfeiture rate and expected volatility over the most recent period commensurate with the estimated expected term of the awards. 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 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,
 
 
2016
 
2015
Net loss
 
$
(7,507
)
 
$
(19,884
)
Foreign currency translation loss
 
(477
)
 
(1,147
)
Comprehensive loss
 
$
(7,984
)
 
$
(21,031
)
Comprehensive Loss
Comprehensive loss consists of net loss and other comprehensive loss. Other comprehensive loss refers to revenues, expenses, gains, and losses that are not included in net loss, but rather are recorded directly in stockholders' equity. For the three months ended March 31, 2016 and 2015, the Company's comprehensive loss consisted of net loss and foreign currency translation losses. The other comprehensive loss presented in the consolidated financial statements and the notes are presented net of tax. There has been no tax expense or benefit associated with the components of other comprehensive loss due to the presence of a full valuation allowance for each of the three months ended March 31, 2016 and 2015.
Advertising Costs
Costs for advertising are expensed as incurred. Advertising expense for the three months ended March 31, 2016 was $9.6 million and for the three months ended March 31, 2015 was $13.4 million.

11

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

Recently Issued Accounting Standards Not Yet Adopted
In March 2016, the FASB issued ASU No. 2016-09, Compensation—Stock Compensation (Topic 718) Improvements to Employee Share-Based Payment Accounting ("ASU 2016-09"). Under ASU 2016-09, accounting for share-based payment award transactions was simplified related to the accounting for (a) income tax effects; (b) minimum statutory tax withholding requirements; (c) and forfeitures. ASU 2016-09 is effective for public entities in annual periods beginning after December 15, 2016, including interim periods within those annual periods. Early adoption is permitted. The Company is in the process of evaluating the adoption date and impact of the new guidance on the Company's consolidated financial statements and disclosures.
In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) ("ASU 2016-02"). Under ASU 2016-02, entities will be required to recognize a lease liability and a right-of-use asset for all leases. Lessor accounting is largely unchanged. ASU 2016-02 is effective for public entities in fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. The Company is in the process of evaluating the impact of the new guidance on the Company's consolidated financial statements and disclosures.
In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities ("ASU 2016-01"). ASU 2016-01 changes how entities measure certain equity investments and present changes in the fair value of financial liabilities measured under the fair value option that are attributable to their own credit. Under the new guidance, entities will be required to measure equity investments that do not result in consolidation and are not accounted for under the equity method at fair value and recognize any changes in fair value in net income unless the investments qualify for the new practicability exception. The accounting for other financial instruments, such as loans and investments in debt securities is largely unchanged. ASU 2016-01 is effective for public entities in fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company does not believe that the adoption of this guidance will have a material impact on the Company's consolidated financial statements and disclosures.
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 May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606), which replaces the current revenue accounting guidance. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date which defers the effective date of the updated guidance on revenue recognition by one year. In March 2016, the FASB issued ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net), which clarifies and improves the operability and understandability of the implementation guidance on principal versus agent considerations. In April 2016, the FASB issued ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing, which clarifies and improves the operability and understandability of the implementation guidance on identifying performance obligations and licensing. Collectively these ASUs comprise the new revenue standard ("New Revenue Standard"). The core principle of the New Revenue Standard 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. The New Revenue Standard is effective for annual periods beginning after December 31, 2017. Entities may choose from two adoption methods, with certain practical expedients. The Company expects that it will adopt the New Revenue Standard beginning in the first quarter of 2018 and is currently evaluating the appropriate transition method and any impact of the New Revenue Standard on the Company's consolidated financial statements and disclosures.

12

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


3. DIVESTITURES
As part of the shift in strategy initiated in early 2015, the Company determined that its ownership of the consumer-oriented Rosetta Stone Korea Ltd. ("RSK") entity no longer agreed with the Company’s overall strategy to focus on the Enterprise & Education Language and Literacy businesses. In September 2015, the Company completed the divestiture of 100% of the Company's capital stock of RSK to the then-current President of RSK for consideration equal to the assumption of RSK's net liabilities at the date of sale.
As part of the transaction, the Company has agreed to continue to provide to RSK certain of its online product offerings for resale and distribution and RSK is committed to purchase those products, for an initial term ending December 31, 2025. In addition, the Company has loaned RSK $0.5 million as of October 2, 2015, which will be repaid in five equal installments due every six months beginning December 31, 2016. As a result of this loan receivable and the level of financial support it represents, the Company concluded that it holds a variable interest in RSK whereby the Company is not the primary beneficiary.  The maximum exposure to loss as a result of this involvement in the variable interest entity is limited to the $0.5 million amount of the loan.
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,
 
 
2016

2015
Numerator:
 
 

 
 

Net loss
 
$
(7,507
)
 
$
(19,884
)
Denominator:
 
 

 
 

Weighted average number of common shares:
 
 

 
 

Basic
 
21,867

 
21,018

Diluted
 
21,867

 
21,018

Loss per common share:
 
 

 
 

Basic
 
$
(0.34
)
 
$
(0.95
)
Diluted
 
$
(0.34
)
 
$
(0.95
)
For the three months ended March 31, 2016 and 2015, 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 (in thousands).
 
 
Three Months Ended 
 March 31,
 
 
2016
 
2015
Stock options
 
25

 
58

Restricted stock units
 
162

 
119

Restricted stocks
 
63

 
69

Total common stock equivalent shares
 
250

 
246


13

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



5. INVENTORY
Inventory consisted of the following (in thousands):
 
 
March 31,
2016
 
December 31,
2015
Raw materials
 
$
3,190

 
$
3,375

Finished goods
 
4,039

 
3,958

Total inventory
 
$
7,229

 
$
7,333

6. GOODWILL
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 acquisition of Livemocha, Inc. ("Livemocha") in April 2013, the acquisition of Lexia Learning Systems, Inc. ("Lexia") in August 2013, and the acquisitions of Vivity Labs, Inc. ("Vivity") and Tell Me More S.A. ("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, 2016 (in thousands):
 
 
Enterprise & Education Language
 
Literacy
 
Consumer
 
Total
Balance as of December 31, 2015
 
$
38,700

 
$
9,962

 
$
1,618

 
$
50,280

Effect of change in foreign currency rate
 
456

 

 
107

 
563

Balance as of March 31, 2016
 
$
39,156

 
$
9,962

 
$
1,725

 
$
50,843

The Company also routinely reviews goodwill at the reporting unit level for potential impairment as part of the Company’s internal control framework. The Company's reporting units were evaluated to determine if a triggering event has occurred. As of March 31, 2016, the Company concluded that there are no indicators of impairment that would cause it to believe that it is more likely than not that the fair value of it's 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.

14

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, 2016
 
December 31, 2015
 
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Net
Carrying
Amount
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Net
Carrying
Amount
Tradename/trademark *
 
$
12,471

 
$
(1,358
)
 
$
11,113

 
$
12,442

 
$
(1,271
)
 
$
11,171

Core technology
 
15,397

 
(8,505
)
 
6,892

 
15,149

 
(7,817
)
 
7,332

Customer relationships
 
26,422

 
(17,348
)
 
9,074

 
26,245

 
(16,603
)
 
9,642

Website
 
12

 
(12
)
 

 
12

 
(12
)
 

Patents
 
300

 
(211
)
 
89

 
300

 
(201
)
 
99

Total
 
$
54,602

 
$
(27,434
)
 
$
27,168

 
$
54,148

 
$
(25,904
)
 
$
28,244

* 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, 2016, 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,
 
 
2016
 
2015
Included in cost of revenue:
 
 
 
 
Cost of product revenue
 
$
48

 
$
79

Cost of subscription and service revenue
 
98

 
67

Total included in cost of revenue
 
146

 
146

Included in operating expenses:
 
 
 
 
Sales and marketing
 
715

 
725

Research and development
 
442

 
456

General and administrative
 

 

Total included in operating expenses
 
1,157

 
1,181

Total
 
$
1,303

 
$
1,327

The following table summarizes the estimated future amortization expense related to intangible assets for the remaining nine months of 2016 and years thereafter (in thousands):
 
 
As of March 31, 2016
2016 - remaining
 
$
3,423

2017
 
4,245

2018
 
3,651

2019
 
1,532

2020
 
1,282

Thereafter
 
2,428

Total
 
$
16,561


15

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, 2016 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, 2016
 
December 31, 2015
Accrued marketing expenses
 
$
16,211

 
$
20,022

Accrued professional and consulting fees
 
1,918

 
1,746

Sales return reserve
 
2,104

 
3,728

Sales, withholding and property taxes payable
 
3,702

 
3,879

Other
 
3,465

 
5,943

Total other current liabilities
 
$
27,400

 
$
35,318

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 $25.0 million revolving credit facility (the “credit facility”). The Company executed the First Amendment to the credit facility with the Bank effective March 31, 2015, the Second Amendment effective May 1, 2015, the Third Amendment effective June 29, 2015, and the Fourth Amendment effective December 29, 2015. The Company is subject to certain covenants 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 in the First, Second, Third, and Fourth Amendments, which were primarily amended to reflect updates to the Company's financial outlook. The Third Amendment also changed the definition of "change of control" to eliminate a clause referring to a change in a portion of the Board of Directors within a twelve-month period.
On March 14, 2016, the Company executed the Fifth Amendment to the credit facility. Under the amended agreement, the Company may borrow up to $25.0 million, including a sub-facility, which reduces available borrowings, for letters of credit in an aggregate availability amount of $4.0 million. Borrowings by RSL under the credit facility are guaranteed by the Company as the ultimate parent. The credit facility has a term that expires on January 1, 2018, during which time RSL may borrow and re-pay loan amounts and re-borrow the loan amounts subject to customary borrowing conditions.
The total obligations under the credit facility cannot exceed the lesser of (i) the total revolving commitment of $25.0 million or (ii) the borrowing base, which is calculated as 80% of eligible accounts receivable. As a result, the borrowing base will fluctuate and the Company expects it will follow the general seasonality of cash and accounts receivable (lower in the first half of the year and higher in the second half of the year). If the borrowing base less any outstanding amounts, plus the cash held at SVB ("Availability") is greater than $25.0 million, then the Company may borrow up to an additional $5.0 million, but in no case can borrowings exceed $25.0 million. Interest on borrowings accrue at the Prime Rate provided that the Company maintains a minimum cash and Availability balance of $17.5 million. If cash and Availability is below $17.5 million, interest will accrue at the Prime Rate plus 1%.
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, including letters of credit, 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.

16

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


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 amount and minimum financial performance requirements, as defined in the credit facility. As of March 31, 2016, 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.
As of March 31, 2016, there were no borrowings outstanding and the Company was eligible to borrow $13.5 million of available credit, less $4.0 million in letters of credit that have been issued by the Bank on the Company's behalf. 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, the Company holds a capital lease for a building near Versailles, France.
During the three months ended March 31, 2016 and 2015, the Company acquired $27,000, and zero, respectively, of 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, 2016
2016-remaining
 
$
391

2017
 
670

2018
 
518

2019
 
515

2020
 
510

Thereafter
 
887

Total minimum lease payments
 
$
3,491

Less amount representing interest
 
462

Present value of net minimum lease payments
 
$
3,029

Less current portion
 
546

Obligations under capital lease, long-term
 
$
2,483

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, 2016 is based on the estimated annual effective tax rate for fiscal year 2016. 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.
Valuation Allowance Recorded for Deferred Tax Assets

17

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

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, 2016, 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, 2016 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, 2016, a valuation allowance was provided for the U.S., 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, 2016 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, 2016, and December 31, 2015, the Company’s U.S. deferred tax liability was $5.1 million and $4.8 million, respectively, related to its goodwill and indefinite lived intangibles. As of March 31, 2016 the Company had foreign net deferred tax liabilities of $0.1 million compared to foreign net deferred tax liabilities of $0.2 million at December 31, 2015. As of March 31, 2016, and December 31, 2015, the Company had no unrecognized tax benefits.
For the three months ended March 31, 2016 the Company recorded an income tax expense of $0.4 million. The expense in the current period is made up of tax expense related to current year profits of operations in Germany and the U.K. Additionally, the tax expense relates to the tax impact of the amortization of indefinite-lived intangible assets 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 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 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.

18

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


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. Concurrent with the approval of the 2009 Plan, the 2006 Plan was terminated for purposes of future grants.
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. On June 12, 2015, the Board of Directors authorized and the Company's shareholders approved the allocation of 1,200,000 additional shares of common stock to the 2009 Plan. At March 31, 2016 there were 2,358,514 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, 2016 and 2015, the fair value of options granted was calculated using the following assumptions:  
 
 
Three Months Ended 
 March 31,
 
 
2016
 
2015
Expected stock price volatility
 
46.1%-47.0%
 
62.6%-63.1%
Expected term of options
 
6 years
 
6 years
Expected dividend yield
 
 
Risk-free interest rate
 
1.24%-1.50%
 
1.19%-1.57%
The following table presents stock-based compensation expense included in the related financial statement line items (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2016
 
2015
Included in cost of revenue:
 
 
 
 
Cost of product revenue
 
$
1

 
$
22

Cost of subscription and service revenue
 
(17
)
 
11

Total included in cost of revenue
 
(16
)
 
33

Included in operating expenses:
 
 
 
 
Sales and marketing
 
79

 
361

Research and development
 
(119
)
 
140

General and administrative
 
477

 
753

Total included in operating expenses
 
437

 
1,254

Total
 
$
421

 
$
1,287


19

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


Stock Options
The following table summarizes the Company's stock option activity from January 1, 2016 to March 31, 2016:
 
 
Options
Outstanding
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Contractual
Life (years)
 
Aggregate
Intrinsic
Value
Options Outstanding, January 1, 2016
 
1,837,165

 
$
10.58

 
7.70
 
$
130,262

Options granted
 
391,939

 
7.46

 
 
 
 
Options exercised
 
(7,117
)
 
4.09

 
 
 
 
Options canceled
 
(67,749
)
 
11.59

 
 
 
 
Options Outstanding, March 31, 2016
 
2,154,238

 
10.01

 
7.91
 
112,622

Vested and expected to vest March 31, 2016
 
1,966,909

 
10.16

 
7.74
 
112,622

Exercisable at March 31, 2016
 
1,269,498

 
$
10.49

 
7.12
 
$
112,622

As of March 31, 2016, there was approximately $4.9 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 2.92 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 in accordance with ASC 718.
Restricted Stock Awards
The following table summarizes the Company's restricted stock award activity from January 1, 2016 to March 31, 2016:
 
 
Nonvested
Outstanding
 
Weighted
Average
Grant Date
Fair Value
 
Aggregate
Intrinsic
Value
Nonvested Awards, January 1, 2016
 
341,579

 
$
10.61

 
$
3,624,153

Awards granted
 
143,655

 
7.46

 
 

Awards vested
 
(75,511
)
 
10.62

 
 

Awards canceled
 
(11,972
)
 
11.37

 
 

Nonvested Awards, March 31, 2016
 
397,751

 
$
9.45

 
$
3,757,554

As of March 31, 2016, future compensation cost related to the nonvested portion of the restricted stock awards not yet recognized in the consolidated statement of operations was $3.5 million and is expected to be recognized over a period of 2.54 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.

20

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


Restricted Stock Units
The following table summarizes the Company's restricted stock unit activity from January 1, 2016 to March 31, 2016:
 
 
Units Outstanding
 
Weighted
Average
Grant Date Fair Value
 
Aggregate
Intrinsic
Value
Units Outstanding, January 1, 2016
 
187,942

 
$
11.16

 
$
1,257,332

Units granted
 

 

 

Units released
 
(20,201
)
 
10.77

 
 
Units cancelled
 
(5,589
)
 
8.50

 
 
Units Outstanding, March 31, 2016
 
162,152

 
11.30

 
1,088,040

Vested and expected to vest at March 31, 2016
 
123,674

 
8.50

 
85,226

Vested and deferred at March 31, 2016
 
110,973

 
$
12.60

 
$
744,629

As of March 31, 2016, no restricted stock units were granted to members of the Board of Directors as part of their compensation packages. Restricted stock units convert to common stock following the separation of service with the Company. Beginning June 2015, all restricted stock unit awards vest quarterly over a one year period from the date of grant, with expense recognized straight-line over the vesting period. Prior to June 2015, all restricted stock unit awards were immediately vested with expense recognized in full on the grant date. The Company's restricted stock units 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. The Company did not grant any restricted stock units prior to April 2009.
12. STOCKHOLDERS' EQUITY
At March 31, 2016, 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, 2016, the Company had shares of common stock issued of 23,308,635 and shares of common stock outstanding of 22,308,635.
On May 8, 2013, the Company filed a universal shelf registration statement to offer equity or issue debt in the amount of $150.0 million, 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 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. For the year ended December 31, 2013, the Company paid $11.4 million to repurchase 1,000,000 shares at a weighted average price of $11.44 per share as part of this program. No shares were repurchased during 2014, 2015, or the three months ended March 31, 2016. 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.

21

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



13. RESTRUCTURING
2016 Restructuring Plan
In the first quarter of 2016, the Company announced and initiated actions with an intent to exit the direct sales presence in almost all of its non-U.S. and non-northern European geographies related to the distribution of Enterprise & Education Language offerings. The Company will also look to initiate processes to close its software development operations in France and China. 
Restructuring charges included in the Company’s unaudited consolidated statement of operations related to the 2016 Restructuring Plan include the following:
Employee severance and related benefits costs incurred in connection with headcount reductions involving employees primarily in China, Brazil, Canada, Spain, Mexico, U.S. and the U.K.; and
Other related costs.
The following table summarizes activity with respect to the restructuring charges for the 2016 Restructuring Plan during the three months ended March 31, 2016 (in thousands):
 
 
Balance at January 1, 2016
 
Cost Incurred
 
Cash Payments
 
Other Adjustments (1)
 
Balance at March 31, 2016
Severance costs
 
$

 
$
2,149

 
$
(369
)
 
$

 
$
1,780

Other costs
 

 
256

 

 

 
256

Total
 
$

 
$
2,405

 
$
(369
)
 
$

 
$
2,036

(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.
2015 Restructuring Plan
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 2015 Restructuring Plan as of March 31, 2016. The Company does not expect to incur any additional restructuring costs in connection with the 2015 Restructuring Plan.
Restructuring charges included in the Company’s unaudited consolidated statement of operations related to the 2015 Restructuring Plan 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.
The following table summarizes activity with respect to the restructuring charges for the 2015 Restructuring Plan during the three months ended March 31, 2016 (in thousands):
 
 
Balance at January 1, 2016
 
Cost Incurred
 
Cash Payments
 
Other Adjustments (1)
 
Balance at March 31, 2016
Severance costs
 
$
252

 
$
104

 
$
(238
)
 
$

 
$
118

Contract termination costs
 

 

 

 

 

Other costs
 

 

 

 

 

Total
 
$
252

 
$
104

 
$
(238
)
 
$

 
$
118

(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.

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


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


Restructuring Cost
The following table summarizes the major types of costs associated with the 2016 and 2015 Restructuring Plans for the three months ended March 31, 2016 and 2015, and total costs incurred through March 31, 2016 (in thousands):
 
 
Three Months Ended 
 March 31,
 
Incurred through
 
 
2016
 
2015
 
March 31, 2016
Severance costs
 
$
2,253

 
$
6,013

 
$
9,493

Contract termination costs
 

 

 
1,134

Other costs
 
256

 
246

 
673

Total
 
$
2,509

 
$
6,259

 
$
11,300

As of March 31, 2016, the entire restructuring liability of $2.2 million was classified as a current liability within accrued compensation and other current liabilities on the consolidated balance sheets.
The following table presents total restructuring costs associated with the 2016 and 2015 Restructuring Plans included in the related line items of our Statement of Operations (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2016
 
2015
Cost of revenue
 
$
95

 
$
37

Sales and marketing
 
1,485

 
3,124

Research and development
 
349

 
604

General and administrative
 
580

 
2,494

Total
 
$
2,509

 
$
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."
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 $3.2 million in the first quarter of 2014. 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.

23

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, 2016 and 2015 is as follows (in thousands):
 
 
As of March 31,
 
 
2016
 
2015
Accrued lease abandonment costs, beginning of period
 
$
1,281

 
$
1,679

Costs incurred and charged to expense
 

 

Principal reductions
 
(110
)
 
(129
)
Accrued lease abandonment costs, end of period
 
$
1,171

 
$
1,550

Accrued lease abandonment costs liability:
 
 
 
 

Short-term
 
$
443

 
$
462

Long-term
 
728

 
1,088

Total
 
$
1,171

 
$
1,550

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 2016 and the years thereafter (in thousands):
 
 
As of March 31, 2016
Periods Ending December 31,
 
 
2016-remaining
 
$
4,007

2017
 
4,366

2018
 
3,829

2019
 
1,253

2020
 
962

Thereafter
 
589

Total
 
$
15,006

Total expenses under operating leases are $1.1 million and $1.4 million for the three months ended March 31, 2016 and 2015, 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.

24

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. A constitutional complaint was filed with the German Federal Supreme Court in May 2015.
In October 2015, the parties subsequently engaged in further settlement discussions and executed a settlement agreement. Pursuant to this settlement agreement, in January 2016, Rosetta Stone GmbH paid a lump sum of $0.4 million in full settlement of all financial claims resulting from the proceedings, including damages and cost reimbursement to Langenscheidt. Both parties have withdrawn the pending motions. As of March 31, 2016, the Company considers this matter closed.
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 2016, the Company announced its strategy to position the organization for success. The Company has prioritized the growth of literacy sales and is taking actions to align resources to drive this growth. As a result of this shift, the Company reevaluated its segment structure. Prior to the strategy shift, the Company was managed in two operating segments - "Enterprise & Education" and "Consumer". Following the shift, the Company is managed in three operating segments - "Enterprise & Education Language", "Literacy", and "Consumer". The new Literacy segment was previously a component of the "Enterprise & Education" segment and is comprised solely of the Lexia business. The Literacy segment focuses on delivering subscription-based English literacy-learning and assessment solutions to grades pre-K through 12. 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. Segment contribution excludes depreciation, amortization, stock compensation, research and development, restructuring related and other non-recurring expenses. The Company does not allocate expenses beneficial to all segments, which includes certain general and administrative expenses such as legal fees, payroll processing fees, and accounting related 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. Prior periods have been reclassified to reflect our current segment presentation and definition of segment contribution.
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.

25

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

Operating results by segment for the three months ended March 31, 2016 and 2015 were as follows (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2016
 
2015
Revenue:
 
 
 
 
Enterprise & Education Language
 
$
18,331

 
$
18,998

Literacy
 
7,577

 
4,170

Consumer
 
22,094

 
35,274

Total revenue
 
$
48,002

 
$
58,442

Segment contribution:
 
 

 
 
Enterprise & Education Language
 
6,100

 
4,195

Literacy
 
1,038

 
(124
)
Consumer
 
4,949

 
7,321

Total segment contribution
 
$
12,087

 
$
11,392

Unallocated expenses, net:
 
 

 
 
Unallocated cost of sales
 
1,021

 
662

Unallocated sales and marketing
 
2,547

 
4,500

Unallocated research and development
 
6,571

 
8,972

Unallocated general and administrative
 
10,135

 
14,994

Unallocated non-operating expense/(income)
 
(1,129
)
 
1,665

Unallocated impairment
 

 
291

Unallocated lease abandonment expense
 

 

Total unallocated expenses, net
 
$
19,145

 
$
31,084

Loss before income taxes
 
$
(7,058
)
 
$
(19,692
)
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, 2016 and 2015 (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2016
 
2015
United States
 
$
39,795

 
$
46,189

International
 
8,207

 
12,253

Total
 
$
48,002

 
$
58,442

The information below summarizes long-lived assets by geographic area classified as held and used as of March 31, 2016 and December 31, 2015 (in thousands):
 
 
March 31,
2016
 
December 31,
2015
United States
 
$
19,460

 
$
18,704

International
 
3,809

 
3,828

Total
 
$
23,269

 
$
22,532


26

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

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, 2016 and 2015 (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2016
 
2015
Language learning
 
$
39,227

 
$
53,165

Literacy
 
7,577

 
4,170

Brain fitness
 
1,198

 
1,107

Total
 
$
48,002

 
$
58,442


27


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 revenue, Adjusted EBITDA, bookings, 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 14, 2016. 
Overview    
Rosetta Stone Inc. ("Rosetta Stone," the "Company," "we" or "us") is dedicated to changing people's lives through the power of language and literacy education. Our innovative, personalized language and reading programs drive positive learning outcomes in thousands of schools, businesses, government organizations and for millions of individuals around the world. Our cloud-based programs allow users to learn online or on-the-go via tablet or smartphone, whether in a classroom, corporate setting, or personal learning environment. Rosetta Stone is also a leader in the literacy education space, helping millions of students build fundamental reading skills. Additionally, our Fit Brains business offers personalized brain training programs that are both exciting and challenging.
Rosetta Stone Inc. was incorporated in Delaware in 2005. Founded in 1992, Rosetta Stone pioneered the use of interactive software to accelerate language learning and is widely recognized today as the industry leader in providing effective language programs. 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 us to meet the changing needs of learners around the world.
As our Company has evolved, we believe that our Enterprise & Education Language and Literacy segments are 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 demand is growing for e-learning based literacy solutions in the U.S. and English language-learning around the globe.
As a result, we are emphasizing the development of products and solutions for Corporate and K-12 learners who need to speak and read English. This focus extends to the Consumer segment, where we continue to make product investments serving the needs of passionate language learners who are motivated, results focused and willing to pay for a quality language-learning experience.
To position the organization for success, we have begun and will continue to focus on the following four priorities:
1.
Grow literacy sales by providing fully aligned digital instruction and assessment tools for K-12, building a direct distribution sales force to replace our historical reseller model, and continuing to develop our implementation services business;
2.
Position our Enterprise & Education Language segment for profitable growth by focusing on our best geographies and customer segments and successfully delivering a new language-learning suite for Corporate customers that offers a

28


simple, more modern, metrics-driven suite of tools that are results-oriented and easily integrated with leading corporate language-learning systems;
3.
Maximize the profitability of our Consumer language business by providing an attractive value proposition and a streamlined, mobile-oriented product portfolio focused on consumers' demand, while optimizing our marketing spend appropriately; and
4.
Right-size the entire cost base of the Company, including
optimizing our media spend and other marketing costs in Consumer sales and marketing;
right-sizing our Enterprise & Education Language segment to target those geographies and customer segments where we have the greatest opportunity; and
reducing our general and administrative costs.
In pursuing these priorities, we will (i) allocate capital to the areas of our business that we believe have the greatest growth potential, including our literacy-learning business, (ii) focus our businesses on their best customers, including Corporate and K-12 learners primarily in North America and Northern Europe in our Enterprise & Education Language segment and passionate learners in the United States and select non-US geographies in our Consumer language business, and (iii) optimize the sales and marketing costs for these businesses and the costs of our business overall.
On March 14, 2016, we announced the 2016 Restructuring Plan, outlining our intent to exit the direct sales presence in almost all of our non-U.S. and non-northern European geographies related to the distribution of the Enterprise & Education Language offerings. Where appropriate, we seek to operate through partners in the geographies being exited. We also look to initiate processes to close the software development operations in France and China. These actions are additive to the 2015 Restructuring Plan to accelerate and prioritize our focus on satisfying the needs of more passionate Corporate and K-12 learners, and emphasizing those who need to speak and read English. If our intentions are realized, the 2016 Restructuring Plan will reduce headcount by approximately 17% of our year-end 2015 full-time workforce and is expected to result in annual cost savings of approximately $19.0 million. As it will take time to exit certain geographies, the full benefit of these changes will not be realized until the later half of 2016 and early 2017. 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 conjunction with the 2016 and 2015 Restructuring Plans, outside financial and legal advisors have been retained to assist management and the Board of Directors with their ongoing comprehensive review to analyze potential options to improve financial performance and enhance shareholder value.
As a result of the strategic reorganization and realignment of the business, as of March 31, 2016, we currently have three operating segments, Enterprise & Education Language, Literacy, and Consumer, rather than the two operating segments (Enterprise & Education and Consumer) we had as of December 31, 2015. The Enterprise & Education Language segment derives language learning revenue from sales to educational institutions, government agencies and corporations worldwide. The Literacy segment derives revenue from the sales of literacy solutions to pre-K-12 educational institutions. The Consumer segment derives revenue from sales to individuals and retail partners. 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 Language segment contribution increased to $6.1 million with segment contribution margin of 33% for the three months ended March 31, 2016 as compared to segment contribution of $4.2 million and segment contribution margin of 22% for the three months ended March 31, 2015. The dollar and margin increases were primarily due to lower sales and marketing expenses due to a reduced headcount and other cost saving measures. Literacy segment contribution increased to $1.0 million with segment contribution margin of 14% for the three months ended March 31, 2016 as compared to a segment contribution loss of $0.1 million and segment contribution margin of negative 3% for the three months ended March 31, 2015. The dollar and margin increases were primarily due to the larger revenue base on which segment contribution is calculated, slightly offset by an increase in sales and marketing expense due to the transition to a direct sales team and support infrastructure. Excluding purchase accounting effects on acquired deferred revenue and deferred commissions, Literacy segment contribution would have increased to $1.8 million with segment contribution margin of 20% for the three months ended March 31, 2016 as compared to similarly adjusted segment contribution of $1.1 million and segment contribution margin of 18% for the three months ended March 31, 2015. The reconciliation from segment contribution includes additional revenue and commissions of $2.3 million and $1.1 million, respectively, for the three months ended March 31, 2015 and additional revenue and commissions of $1.4 million and $0.6 million, respectively, for the three months ended March 31, 2016. Consumer segment contribution decreased from $7.3 million with a segment contribution margin of 21% for the three months ended

29


March 31, 2015 to $4.9 million with a segment contribution margin of 22% for the three months ended March 31, 2016. The dollar decrease in Consumer segment contribution reflects the $13.2 million decrease in Consumer revenue. The Consumer segment contribution margin increased due to a reduction in media spend and other cost reduction initiatives to align Consumer segment spending with our strategic focus on the Enterprise & Education Language and Literacy segments.
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. We expect the trend in Consumer subscription sales to accelerate in 2016 as customer preferences continue to move towards mobile experiences. Over the approximate next 18 months, we intend to move all of our Consumer business to subscription sales.
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 segment 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 consists 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 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% to 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 sell to enterprise and education organizations primarily through our direct sales force as well as through our network of resellers and organizations who typically gain access to our solutions under a web-based subscription service. 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 and distributors. For purposes of explaining variances in our revenue, we separately discuss changes in our Enterprise & Education Language, Literacy, and our Consumer sales channels because the customers and revenue drivers of these channels are different.
Within our Enterprise & Education Language segment, revenue in our education, government, and corporate sales channels are seasonally stronger in the second half of the calendar year due to purchasing and budgeting cycles. Our Literacy segment revenue is seasonally stronger in the second quarter of the calendar year corresponding to school district budget years. Our Consumer revenue is affected by seasonal trends associated with the holiday shopping season. 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

30


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, and general and administrative. When certain events occur, we also recognize operating expenses related to asset impairment and operating lease terminations.
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.
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.
Research and Development.    Research and development expenses consist primarily of employee compensation costs, consulting fees, and overhead costs associated with 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.
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.
Impairment.   Impairment expenses consist primarily of goodwill impairment and impairment expense related to the abandonment of previously capitalized internal-use software projects.
Interest and Other Income (Expense)
Interest and other income (expense) primarily consist of interest income, interest expense, foreign exchange gains and losses, income from litigation settlements, and income or loss from equity method investments. Interest income represents interest received on our cash and cash equivalents. Interest expense is primarily related to interest on our capital leases and amortization of deferred financing fees associated with our revolving credit facility. 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 or loss from equity method investments represents our proportionate share of the net income or loss of our investment in entities accounted for under the equity method.
Income Tax Expense
Income tax expense consists of federal, state and foreign income taxes. We regularly evaluate the recoverability of our deferred tax assets and establish a valuation allowance, if necessary, to reduce the deferred tax assets to an amount that is more likely than not to be realized (a likelihood of more than 50 percent). Significant judgment is required to determine whether a valuation allowance is necessary and the amount of such valuation allowance, if appropriate.
The establishment of a valuation allowance has no effect on the ability to use the deferred tax assets in the future to reduce cash tax payments. We assess the likelihood that the deferred tax assets will be realizable at each reporting period, and the valuation allowance will be adjusted accordingly, which could materially affect our financial position and results of operations.
For the three months ended March 31, 2016, we incurred an income tax expense of $0.4 million, despite incurring losses before taxes of $7.1 million, respectively, resulting in worldwide effective tax rates of (6.4)%. This tax rate resulted from tax expense related to current year income of operations in Germany and the U.K. and the tax impact of amortization of indefinite lived intangibles. This was offset by tax benefits related to current year losses in Canada.
For the year ended December 31, 2015, we recorded an income tax benefit of $1.2 million primarily attributable to losses before tax of $45.6 million resulting in worldwide effective tax rate of (2.5)%. 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 income of

31


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. In addition, we believe that a discussion of these policies is necessary for readers to understand and evaluate our consolidated financial statements contained in this annual report on Form 10-Q:
Revenue Recognition
Stock-based Compensation
Goodwill
Intangible Assets
Valuation of Long-Lived Assets
Restructuring Costs
Income Taxes
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 14, 2016. 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.

32


Results of Operations
Comparison of the three months ended March 31, 2016 and the three months ended March 31, 2015
The following table sets forth our consolidated statement of operations for the periods indicated (in thousands, except percentages):
 
 
Three Months Ended March 31,
 
2016 Versus 2015
 
 
2016
 
2015
 
Change
 
% Change
Revenue:
 
 
 
 
 
 
 
 
Product
 
$
10,031

 
$
19,974

 
$
(9,943
)
 
(49.8
)%
Subscription and service
 
37,971

 
38,468

 
(497
)
 
(1.3
)%
Total revenue
 
48,002

 
58,442

 
(10,440
)
 
(17.9
)%
Cost of revenue:
 
 
 
 
 
 
 
 
Cost of product revenue
 
2,645

 
5,637

 
(2,992
)
 
(53.1
)%
Cost of subscription and service revenue
 
5,403

 
5,665

 
(262
)
 
(4.6
)%
Total cost of revenue
 
8,048

 
11,302

 
(3,254
)
 
(28.8
)%
Gross profit
 
39,954

 
47,140

 
(7,186
)
 
(15.2
)%
Operating expenses:
 
 
 
 
 
 
 
 
Sales and marketing
 
30,793

 
40,150

 
(9,357
)
 
(23.3
)%
Research and development
 
6,571

 
8,972

 
(2,401
)
 
(26.8
)%
General and administrative
 
10,777

 
15,754

 
(4,977
)
 
(31.6
)%
Impairment
 

 
291

 
(291
)
 
(100.0
)%
Total operating expenses
 
48,141

 
65,167

 
(17,026
)
 
(26.1
)%
Loss from operations
 
(8,187
)
 
(18,027
)
 
9,840

 
(54.6
)%
Other income and (expense):
 
 
 
 
 
 
 
 
Interest income
 
13

 
4

 
9

 
225.0
 %
Interest expense
 
(112
)
 
(88
)
 
(24
)
 
27.3
 %
Other income and (expense)
 
1,228

 
(1,581
)
 
2,809

 
(177.7
)%
Total other income and (expense)
 
1,129

 
(1,665
)
 
2,794

 
(167.8
)%
Loss before income taxes
 
(7,058
)
 
(19,692
)
 
12,634

 
(64.2
)%
Income tax benefit
 
449

 
192

 
257

 
133.9
 %
Net loss
 
$
(7,507
)
 
$
(19,884
)
 
$
12,377

 
(62.2
)%
Total revenue decreased to $48.0 million for the three months ended March 31, 2016 from $58.4 million for the three months ended March 31, 2015. The change in revenue is due to a decrease in Consumer revenue of $13.2 million, a decrease in Enterprise & Education revenue of $0.7 million, and an increase in Literacy revenue of $3.4 million.
The operating loss for the three months ended March 31, 2016 totaled $8.2 million, compared to an operating loss of $18.0 million for the three months ended March 31, 2015. Operating expenses decreased $17.0 million, primarily comprised of decreases of $9.4 million in sales and marketing expenses, $5.0 million in general and administrative expenses, and $2.4 million in research and development expenses. The decrease in operating expenses reflects the cost savings as a result of the actions taken in 2015 to reduce expenses. The overall decrease in operating expenses was partially offset by a decrease in gross profit of $7.2 million, driven by a $10.4 million decrease in revenue only partially offset by a $3.3 million decrease in cost of revenue.

33


The following table sets forth revenue for our three operating segments for the three months ended March 31, 2016 and 2015 (in thousands, except percentages):
 
 
Three Months Ended March 31,
 
2016 Versus 2015
 
 
2016
 
 
 
2015
 
 
 
Change
 
% Change
Enterprise & Education Language
 
$
18,331

 
38.2
%
 
$
18,998

 
32.5
%
 
$
(667
)
 
(3.5
)%
Literacy
 
7,577

 
15.8
%
 
4,170

 
7.1
%
 
3,407

 
81.7
 %
Consumer
 
22,094

 
46.0
%
 
35,274

 
60.4
%
 
(13,180
)
 
(37.4
)%
Total Revenue
 
$
48,002

 
100.0
%
 
$
58,442

 
100.0
%
 
$
(10,440
)
 
(17.9
)%
Enterprise & Education Language Segment
Enterprise & Education Language revenue decreased $0.7 million, or 4%, from the three months ended March 31, 2015 to the three months ended March 31, 2016. The decrease in Enterprise & Education Language revenue reflects a decrease of $1.2 million in the corporate channel, which was partially offset by increases of $0.3 million and $0.2 million in our education and non-profit channels, respectively. We expect revenue associated with the Enterprise & Education Language business will decline as we execute our strategy to exit our direct presence in unprofitable geographies and manage this business for profitable growth. Where appropriate, we will seek to operate in the geographies we exit through partners.
Literacy Segment
Literacy revenue increased $3.4 million, or 82%, from the three months ended March 31, 2015 to $7.6 million for the three months ended March 31, 2016. Literacy revenue increased, in part, 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 was recorded at fair value, which is lower than the book value, and resulted in lower first quarter 2015 revenue. We continue to experience these purchase accounting impacts for the Literacy segment due to the typical subscription length. As a result, we expect year over year revenues to become more comparable as we move beyond the purchase accounting impact, which we expect to result in lower revenue growth rates than what we experienced in the first quarter of 2016. Excluding the impact of purchase accounting, Literacy revenue would have increased $2.5 million, or 38%, from the three months ended March 31, 2015 to $9.0 million for the three months ended March 31, 2016. The reconciliation from Literacy revenue includes additional revenue of $2.3 million and $1.4 million for the three months ended March 31, 2015 and 2016, respectively.
Consumer Segment
Consumer revenue decreased $13.2 million, or 37%, from the three months ended March 31, 2015 to the three months ended March 31, 2016. This decrease was primarily due to reductions in revenue from our direct-to-consumer, retail, and homeschool sales channels of $9.6 million, $3.0 million, and $0.7 million, respectively. These declines reflect the decision to significantly curtail promotional pricing under our strategic transformation. In 2014, 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 recent shift in strategy to focus on the passionate learner, we have been and expect to be more disciplined with pricing, relying much less on discounting, which may continue to negatively impact our Consumer revenue. Our Consumer business is seasonal and typically peaks in the fourth quarter during the holiday shopping season.
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 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% to 35% of the revenue of each of these bundled sales. We recognize the deferred revenue over the term of the service period.

34


The following table sets forth revenue for products and subscription and services for the three months ended March 31, 2016 and 2015 (in thousands, except percentages):
 
 
Three Months Ended March 31,
 
 
 
2016 Versus 2015
 
 
2016
 
 
 
2015
 
 
 
Change
 
% Change
Product
 
$
10,031

 
20.9
%
 
$
19,974

 
34.2
%
 
$
(9,943
)
 
(49.8
)%
Subscription and service
 
37,971

 
79.1
%
 
38,468

 
65.8
%
 
(497
)
 
(1.3
)%
Total revenue
 
$
48,002

 
100.0
%
 
$
58,442

 
100.0
%
 
$
(10,440
)
 
(17.9
)%
Product Revenue
Product revenue decreased $9.9 million, or 50%, to $10.0 million during the three months ended March 31, 2016 from $20.0 million during the three months ended March 31, 2015. The primary drivers of the decrease in product revenue were decreases of $6.5 million, $3.1 million, and $0.2 million in the direct-to-consumer, retail, and homeschool sales channels, respectively, within our Consumer segment which reflect the decision to significantly curtail promotional pricing under our strategic transformation. The majority of the product revenue decrease was due to the year-over-year decline in product unit sales volume and secondarily due to the decrease in the average sale price of our bundled language-learning software products. We expect a shift away from product revenue as we carry out our strategy to accelerate the migration of our Consumer business to our subscription-based products. However, it is important to note that these subscribers generally only stay for the duration of the subscription period, which could negatively impact our revenue in the future.
Subscription and Service Revenue
Subscription and service revenue decreased $0.5 million, or 1%, to $38.0 million for the three months ended March 31, 2016 from $38.5 million for the three months ended March 31, 2015. The decrease in subscription and service revenue was due to decreases of $3.3 million in the Consumer segment and $0.6 million in the Enterprise & Education Language segment, mostly offset by an increase of $3.4 million in the Literacy segment. The Consumer segment experienced decreases of $3.1 million and $0.4 million in the direct-to-consumer and homeschool sales channels, respectively, slightly offset by increases of $0.1 million and $0.1 million in the retail and brain fitness sales channels, respectively. The Enterprise & Education Language business realized a decrease of $0.9 million in the corporate sales channel, partially offset by increases of $0.3 million and $0.1 million in our non-profit and eduction sales channels, respectively. These decreases to subscription and service revenue were mostly offset by the 82% increase in Literacy revenue. Our first quarter 2015 subscription and service revenue was lower due to the write-down effects of purchase accounting on the pre-acquisition deferred revenue balances associated with the Lexia acquisition. We continue to experience these purchase accounting impacts in the Literacy segment due to the typical subscription length. As a result, we expect the growth rates from our Literacy segment to lessen over time.
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, 2016 and 2015 (in thousands, except percentages):
 
 
Three Months Ended March 31,
 
2016 Versus 2015
 
 
2016
 
2015
 
Change
 
% Change
Revenue:
 
 
 
 
 
 
 
 
Product
 
$
10,031

 
$
19,974

 
$
(9,943
)
 
(49.8
)%
Subscription and service
 
37,971

 
38,468

 
(497
)
 
(1.3
)%
Total revenue
 
48,002

 
58,442

 
(10,440
)
 
(17.9
)%
Cost of revenue:
 
 
 
 
 
 
 
 
Cost of product revenue
 
2,645

 
5,637

 
(2,992
)
 
(53.1
)%
Cost of subscription and service revenue
 
5,403

 
5,665

 
(262
)
 
(4.6
)%
Total cost of revenue
 
8,048

 
11,302

 
(3,254
)
 
(28.8
)%
Gross profit
 
$
39,954

 
$
47,140

 
$
(7,186
)
 
(15.2
)%
Gross margin percentages
 
83.2
%
 
80.7
%
 
2.5
%
 
 
Total cost of revenue decreased $3.3 million for the three months ended March 31, 2016 from $11.3 million for the three months ended March 31, 2015. The change in total cost of revenue was primarily due to a $1.4 million decrease in physical

35


inventory costs due to the reduction in sales, a $0.4 million decrease in communication expense due to a reduction in hosting fees, a $0.3 million decrease in payroll expense primarily driven by the reduced headcount and severance expenses from the 2015 Restructuring Plan, and a $0.3 million decrease in professional services due to reduced spending on outside services for product support.
Cost of Product Revenue
Cost of product revenue for the three months ended March 31, 2016 was $2.6 million, a decrease of $3.0 million, or 53%, from the three months ended March 31, 2015. As a percentage of product revenue, cost of product revenue decreased to 26% for the three months ended March 31, 2016 compared to 28% for the three months ended March 31, 2015. The dollar and percentage decrease in cost of product revenue is primarily due to decreases of $0.8 million, $0.7 million, $0.3 million, $0.3 million, and $0.3 million in inventory costs, payroll and benefits, freight, commission and processing fee costs, respectively, due to the shift away from hard product sales to online subscription sales.
Cost of Subscription and Service Revenue
Cost of subscription and service revenue for the three months ended March 31, 2016 was $5.4 million, a decrease of $0.3 million, or 5%, from the three months ended March 31, 2015. As a percentage of subscription and service revenue, cost of subscription and service revenue decreased to 14% for the three months ended March 31, 2016 compared to 15% for the same prior year period. The dollar and percentage decrease was primarily due to a decrease in expenses as a result of the cost reduction efforts that were partially offset due to increases in allocated costs from a higher allocation rate associated with the increase in subscription and service revenue. We expect the cost of subscription and service revenue will increase as we focus our business around the Enterprise & Education business and accelerate the migration of our Consumer business to our subscription-based products.
Gross Profit
Gross profit decreased $7.2 million to $40.0 million for the three months ended March 31, 2016 compared to the three months ended March 31, 2015. Gross profit percentage increased to 83% from 81% for the three months ended March 31, 2016 compared to the three months ended March 31, 2015. The dollar decrease in gross profit was primarily due to the decrease in revenue. The percentage increase in gross profit percentage was primarily due to the decrease in inventory and freight costs associated with hard product sales as we continue to shift to online subscription sales.
Operating Expenses
 
 
Three Months Ended March 31,
 
2016 Versus 2015
 
 
2016
 
2015
 
Change
 
% Change
 
 
(in thousands, except percentages)
Sales and marketing
 
$
30,793

 
$
40,150

 
$
(9,357
)