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January 14, 2007

Napster Buys AOL Music: What’s Next?

Michael Arrington

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Napster is one of the oddest companies. It is a deeply unprofitable startup trying to grow a business, and with a huge war chest of cash. We have the rare ability to see deep into its financial situation because it is publicly held.

Napster sells music subscriptions and the odd DRM’d download. Pay $10 per month and listen to any of the music in their library. This is a tricky, low margin business. There’s lots of price competition (see our comparison of the space here), and the labels and credit card companies take the vast majority of the revenue. In the last fiscal quarter, Napster had nearly $26 million in revenue but just $7 million of that didn’t go the labels and other costs of goods sold. Caving into this margin pressure, Virgin Music bailed out of the U.S. market just a few days ago.

Napster hired an investment bank in September to sell themselves. At the time they were losing $10 million in cash per fiscal quarter, and had $100 million in the bank. I called them unhealthy. Since that time, they’ve reported another fiscal quarter. They had stellar subscription growth, adding 48,000 subscribers. But they lost even more cash - another $11.6 million. This is a company with operating margins of -38%. And they were sued for patent infringement just a week and a half ago.

Now they’ve announced the acquisition of AOL Music’s subscription service. They’ll add 350,000 new subscribers, get promotion on AOL, and pay just $15 million in cash. It’s not a bad deal, except it adds more unprofitable customers to the struggling company, and the company’s war chest just got significantly lighter. That’s one less fiscal quarter Napster has in operating cash.

It’s unusual to see a company make acquisitions when it is itself on the market. Maybe this is Napster’s signal that the sales process isn’t going well. Or perhaps they just took this opportunity to further consolidate the market. Either way, I’m looking forward to next quarter’s financial results, which should be announced shortly.

One point of clarification. The New York Times reported that Napster paid just $43 per AOL subscriber, compared to their own valuation of $328 per subscriber. Their calculations were incorrect - they used the Napster stock price after the deal was announced, which had spiked sharply. And they failed to take into account that the majority of Napster’s market capitalization is from the $90 million or so they have in cash. Take those factors into account, and Napster’s per subscriber valuation is around just $90.

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This entry was posted on Sunday, January 14th, 2007 at 1:28 am and is filed under Company & Product Profiles. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.

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Comments

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  1. Morgan

    January 14th, 2007 at 2:36 am

    Don’t know the first thing about Napster’s business outlook, but I do actually like their new model. you can listen to ANYTHING I think three times for free. Unlike Rhapsody that just lets you listen to the radio channels, you can actually listen to albums all the way through even if you just have the free account. Great for trying before you buy– maybe that’s the problem.

    I’m surprised they don’t do any better than they do, but of course, that’s because I’m fairly clueless of the numbers. But I wish them luck.

  2. e-tech

    January 14th, 2007 at 3:24 am

    “Not too interesting, but hey, as long as I benefit from it, I’m happy.”

    Exactly~!

  3. Basu

    January 14th, 2007 at 4:57 am

    They might be considering a revamp of their service. Buying out AOL means that if they make a big change in biz plan, they’ll have a much wider base to stand on and maybe reap more benefits.

  4. Rajeev Vashisht

    January 14th, 2007 at 4:58 am

    But the internet economy is real bad. In India I gave a classified in a leading daily of 5 lakh circulation and generate as few as 100 pageviews.
    Too bad scenario.

    http://blogs.ibibo.com/TechnicalJournal

  5. Jeff

    January 14th, 2007 at 6:04 am

    What’s going on here in comments? Somebody pretends to be Mike? :)

  6. Adam benayoun

    January 14th, 2007 at 6:06 am

    i am sure they will find out some way to profit from this acquisition.
    they will need to change their business plan, failure to do so will force them to close faster.

  7. Adam benayoun

    January 14th, 2007 at 6:08 am

    its not mike, you can know if its him by looking at the background color of its comments. they are different than regular comments.

  8. Patrick Aievoli

    January 14th, 2007 at 7:13 am

    Napster is just an example of a pioneer suffering from early market position. Their business plan may not have accounted for major innovations like the iPod or iTunes. These innovations shifted the marketplace. They now are trying to play catch up from an older position. The largest marketplace - high school and college students simply do not buy music. They find sites where it is free and download it. Their parents sometimes force them to buy it through gift cards or guilt. You would have thought that Virgin would have known this. But age does cloud judgment whether older or younger.

  9. Alex Yurek

    January 14th, 2007 at 9:14 am

    Is there any subscription based download service that is profitable at this time? By the looks of it the best that anyone is doing is breaking even which is the iTunes store. Such a shame that the record companies won’t even allow people to get content how they want it at a good price.

  10. Jonas Brandon

    January 14th, 2007 at 9:21 am

    Are there any “free” subscription style services supported by advertising?

  11. Allen

    January 14th, 2007 at 9:30 am

    > Unlike Rhapsody that just lets you listen to the radio channels, you can actually listen to albums all the way through even if you just have the free account.

    But for a mere ten bugs/month with Rhapsody you can listen to anything in their library as many (or as few) times as you’d like with additional charges or penalties–five bucks more and you can do the same with your (compatible) portable device.

  12. EmEhRKay

    January 14th, 2007 at 10:40 am

    Does anyone know the specifics of Napster’s business model; what licenses they have, agreements reached for payment terms? Because when reading some of the license holder agreements, they seem to say no more than 5% of your gross revenue brought in. I must be missing something…

    Thanks.

  13. David Mackey

    January 14th, 2007 at 10:55 am

    I really like the new Napster and use it more than any other to find music I like to listen to. I also like the fact that I can link to any song I like so friends can hear it. I haven’t bought anything from them though, because I’m not a big music listener. That’s why they were smart to integrate ads. I wonder if they allow you to hook directly up to your checking account to pay instead of credit cards? This would help them avoid fees - and for a small incentive might be worth the cost. Is there any way around these fees credit cards charge on small transactions? I understand them to be a decent bit - and on a $1.00 purchase you get barely nothing back (I remember gas companies used to complain about them).

  14. Brian Massey

    January 14th, 2007 at 10:59 am

    It would be good to update the Music site comparison done in April.

    Virgin is now using Napster as its service and is boasting over $3 million songs. They’re moving aggressively by giving away MP3 players for 3 month commitments at $14.95.

    I’ve recently tried Yahoo! music and Urge, and had to resort to burning songs to CD and re-ripping them to MP3 to us across my network and devices. Napster claims they deliver MP3s. We’ll just have to see.

  15. Ben Strackany

    January 14th, 2007 at 11:20 am

    I have to believe that Napster isn’t so nutty as to buy more market share in a money-losing niche w/o a plan. Maybe that figure they’ll be able to raise prices w/ more subscribers? Maybe they have a deal in the works where they’re able to keep more of the profit?

    I assume the labels want Napster et al. to stay afloat. Companies need to be able to make ends meet in this market in order to stick around & keep market share away from allofmp3 or illegal p2p filesharing.

  16. Josh

    January 14th, 2007 at 11:33 am

    They cannot continue to survive and lose money every quarter.

    Not a good sign when the more subscribers you have, the greater the loss. That is the first thing that will have to change. Consolidating the industry with the acquisition would be smart, accept for the fact that so many other sites offer nearly the exact same service.

    There is nothing that differentiates Napster from its competitors.

  17. Isaac

    January 14th, 2007 at 11:56 am

    This isn’t a bad acquisition at all. Napster will obviously live or die by the profit/loss per customer, and if it takes two more years to break even, they’re probably dead anyway. Adding more customers doesn’t actually make it any harder to achieve per-customer profit (possibly makes it easier), so if they’re betting they can get their margins up, they’re best off doing it with as many customers as possible.

  18. Jimmy

    January 14th, 2007 at 1:58 pm

    More customers == higher acquisition value.

  19. Dave G.

    January 14th, 2007 at 2:05 pm

    Well, if the customer aquisition numbers are correct…these 350,000 new users should be profitable for Napster. The deal makes a ton of sense for them - they are getting a large base of new users at half price.

  20. hip2b2

    January 14th, 2007 at 2:19 pm

    Now the question is what Napster will be doing next? Will it continue to be “just another online music store”?

  21. Don Wilson

    January 14th, 2007 at 2:28 pm

    If I were Napster I would switch to the buy-per-song method and give it’s current userbase 10 free songs for every month they’ve been registered with them. This would allow for a quick switch to the per-song purchase method.

  22. Jon

    January 14th, 2007 at 2:46 pm

    As long as Ipod remains popular, I don’t think Napster can do well…

  23. Patent-Monkey

    January 14th, 2007 at 2:54 pm

    Mike - I’m sure one could also imply that the Napster TM has some value bringing the customer value even closer in line. Shows some insight of cost of acquisition in the space too.

    From their quarterly filing, they spent $6mm on advertising for the 3rd quarter and burned $7mm in operating cash flow. The result of that advertising spend was a decrease in revenues from last quarter and 2 quarters ago? Concerning to be sure.

    On the acquisition, this deal should basically bring almost solely sales and a related 25-30% gross margin to Napster on 350k accounts. Quick math would say that Dave G. is probably right that the incremental P&L probably nets Napster an added $3-4mm a quarter (using 350k members, $15/month, 25% gross margin, range based on the fixed added service expenses).

    Tightening in their marketing/customer acquisition program could get them closer to break even on an annual basis, though, it does little to fix the larger strategic issues of being a distant follower.

  24. WTHarvey

    January 15th, 2007 at 2:53 am

    $90/subscriber? Take the market cap of NAPS the day before the announcement at $165M ($3.68 per share) and subtract the cash (less acquisition cost) and you get $90 million for the value of 566,000 subscribers which works out to $160 per subscriber.

  25. Chris Brainard

    January 15th, 2007 at 12:44 pm

    I personally hate Napster and stopped using their service. It was great when it began but they started dropping albums that you could listen to and made it total hell to cancel.

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