Napster now legitimate, but success is uncertain

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July 31, 2005|By Leon Lazaroff | Leon Lazaroff,CHICAGO TRIBUNE

NEW YORK - Napster Inc., the file-sharing company with the groovy name and a checkered past, may be legitimate now, but that's no guarantee of long-term success.

The company has been burning through a lot of cash, though it expects to be profitable in a couple of years.

Of course, a bunch of Internet-based companies said the same thing, and they went bankrupt. They had no underlying business, and all the venture capital in the world wasn't going to save a financial phantom.

But when it comes to file sharing - downloading music and movies - a business is there.

"We think subscription music is going to explode - it's a great product," said Kit Spring, an Internet media analyst at Denver-based Stifel, Nicolaus & Co. Inc. "Consumers don't understand it yet, but once they do, it will be very big."

As the first of its kind and the object of an intense music industry legal attack, Napster has great name recognition. The recent Supreme Court decision on Grokster increased it.

By ruling that file-sharing companies that don't pay royalties might be liable for copyright infringement, the Supreme Court handed Napster a stamp of approval. In 2001, Napster was forced to halt operations after a federal court ruled that it had encouraged the exchange of copyrighted music. Napster was purchased out of bankruptcy and turned into a royalty-paying subscription music service.

"It's a mind-share factor," said Barbara Coffey, a Brean Murray & Co. analyst who has a "buy" rating on the stock. "People think file sharing and they know Napster is legitimate."

Napster has an attractive product: its $14.95-a-month Napster to Go service that gives users unlimited downloads onto portable MP3 players.

But unlike a few years ago, Napster faces some formidable competitors, including Yahoo's Musicmatch, RealNetworks and Apple's iTunes, the reigning king of the hill.

Like the Internet companies of lore, Napster is valued on indicators other than earnings.

First, there's subscriber growth. When Napster releases fiscal first-quarter results Wednesday, it is expected to have added 25,000 subscribers, a sharp deceleration from the 86,000 full-paying ones added in the fourth quarter. Spring sees the work of Yahoo and others here. Excluding seasonal university clients, Napster has about 381,000 full-paying subscribers.

Then there's the issue of cash.

Spring expects first-quarter revenue to total $20 million. But nearly $16 million of that goes directly to the record companies as royalties - the cost of being legitimate. All told, Napster is likely to have burned through $27 million - $20 million of that for marketing.

With $132 million in cash at the end of March, and going through about $27 million a quarter, Napster has roughly until late 2006 to significantly improve its operating margins or risk imploding.

Napster is expected to lose $2.14 a share this fiscal year, according to Thomson Financial.

Its loss from continuing operations was $68.1 million in its most recent fiscal year, up sharply from a year earlier.

Spring is neutral on the stock, which traded above $10 as recently as December but took a dive and has been at about half that of late. If there is investor upside, it's as a takeover target: Napster could fetch $6 or more a share, he said.

Coffey urges patience. She has an $8 price target on the stock. "Napster has [subscriber] growth and a great name," she said. "There's certainly value there."

But with iTunes accounting for seven of every 10 songs downloaded (according to Nielsen SoundScan), analyst Steven Frankel at Adam Harkness in Boston is far less sanguine.

"You have to be powerful enough to get through this competitive landscape and attract customers profitably," said Frankel, who rates Napster a "reduce," one step above "sell."

"At the moment I don't have high confidence in them being able to do that," he said.

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