Napster sings the blues

Napster, once hailed as the king of digital music, has fallen on hard times. Its stock is down 35% this year alone, and 55% from its 52-week high set in October 2007. Resulting shareholder ire forced the company to announce last week that it is seeking strategic alternatives to boost value, and it has hired UBS Investment Bank to lead the effort. Who might acquire the house that Shawn Fanning built?

Since relaunching as a legal music service in late 2003, Napster has been unable to turn a profit. The company pulled in $125m in revenue for the trailing 12 months ended June 30 from about 708,000 paid subscribers. Despite increasing revenue 15% year-over-year, the company had a negative EBITDA of $12.3m and subscriber count decreased from last quarter’s total of 761,000. The switch from stagnation to a drop in subscribers for the first time means that Napster will be unable to keep growing revenue. Consequently, that makes it doubtful that it will be able to achieve profitability. Nevertheless, with $36.9m in cash and $30.7m in short-term investments, Napster is an attractive target at its current valuation of $62.25m.

We previously speculated that SanDisk would attempt to acquire a proprietary music service of its own. But given its financial woes, as well as reported takeover negotiations with Samsung, we do not think it will bite. We believe Napster’s fierce competitor RealNetworks, the majority owner of the Rhapsody music service, is the most likely acquirer. Amid growing competition from Apple, which unveiled its iTunes 8 and a new line of iPods this week, and with digital music newcomers Amazon, Nokia and a few promising startups making waves, this is a much more plausible proposition. Last year Rhapsody picked up Viacom’s Urge, which had been struggling despite its high-profile association with MTV and Microsoft. RealNetworks has the cash, and has repeatedly told us it is bullish on acquisitions that spur growth. Given Napster’s current valuation and similar deals, we estimate that it will fetch around $80-100m in a sale.

SanDisk amps up its music player offerings

With its $6.5m tuck-in acquisition of MusicGremlin last week, SanDisk is bulking up its digital music player business. MusicGremlin, with just eight employees and about $5m in revenue, will obviously not have a material effect on SanDisk’s business. Nonetheless, the importance is not so much the size or scope of the company, but more the technology it has developed during its four years in operation. Specifically, MusicGremlin gives SanDisk the ability to effectively stream music wirelessly to its products. We have learned that SanDisk was very eager to acquire the startup, with the large company initiating talks and sealing a deal within a few weeks. Given SanDisk’s recent effort to build its product offerings through strategic acquisitions, what other acquisitions might the company be considering?

From our perspective, SanDisk needs to do some shopping. It currently ranks a distant second place to Apple in the digital music player market, but also faces stiff competition from the likes of Microsoft, Sony and Panasonic. Perhaps the biggest hole in SanDisk’s offerings is the lack of an in-house music and video content provider, like Apple has with its iTunes and Microsoft has with its Zune Marketplace. To date, SanDisk has relied exclusively on partnerships, but learned the downside of that strategy the hard way in February, when Yahoo suddenly shuttered its Music Unlimited service. The disappearance of the service, which was the very foundation of SanDisk’s Sansa Connect player, left users understandably sour.

As to where SanDisk might look for a music service, two names come to mind: Rhapsody (owned by RealNetworks) and Napster. Despite taking in about $150m and $130m last year, respectively, both are consistently running at a loss. Clearly they could be had for a steal. More importantly, they are both proven and established music services with mobile offerings that would make integrating MusicGremlin’s technology an easy task. Using Napster as a comparable, we believe either company can be had for just under $100m, representing a 40% premium over Napster’s current price on Nasdaq. With $1.22bn in cash and a market cap of $5.2bn, SanDisk could certainly afford a few deals to shore up its defenses for the inevitable battle of the titans.