Napster Takeover Looms as Funds See Cash Exceed Stock

Date: Monday, July 21, 2008
Author: Don Jeffrey, Bloomberg

Napster Inc., the Internet music pioneer whose shares have plunged 95 percent in six years, has become takeover bait for hedge funds zeroing in on a cash hoard exceeding the company's market value.

While Los Angeles-based Napster hasn't posted a profit in four years, its $69.8 million in cash and investments as of March 31 eclipsed the shares' $52.1 million value before today. The company's biggest investor, New York-based hedge fund Eminence Capital LLC, boosted its stake to 9 percent in the second quarter, according to regulatory filings.

Napster may be an attractive target for a buyer like JDS Capital Management Inc., the New York hedge fund that owns digital-music retailer eMusic.com, said Ken Smith, a portfolio manager at Munder Capital Management. The Birmingham, Michigan- based firm, which oversees $30.9 billion, increased its shares by 36 percent as of March 31, according to filings.

``The valuation's absolutely dirt cheap,'' Smith said. ``The scenario that provides the highest value for shareholders is a sale to a strategic buyer,'' he said. Referring to JDS, Smith added, ``That's the type of strategic buyer you need.''

JDS bought 1 million shares of Napster in the first quarter, according to filings.

``We can't comment on any of the purchases we've done,'' said JDS President Danny Stein.

Smith, whose firm owned 6.1 percent of the company as of March 31, wouldn't say if Munder had bought more shares since then. Eminence's chief operating officer, Steve Maresco, declined to comment.

Marketing Cut

Napster Chief Executive Officer Christopher Gorog has built up cash by slashing sales and marketing expenses 90 percent to $18 million in the year ending in March. The reduction came as revenue rose 15 percent to $127.5 million.

The shares, which sold for $25.29 in April 2002, sank to a record-low $1.05 on July 16. Napster rose 30 cents, or 28 percent, to $1.39 at 4 p.m. New York time in Nasdaq Stock Market trading, the biggest gain since May 2001.

``Investors are recognizing that at these levels, it's definitely an attractive takeout play for somebody,'' Piper Jaffray & Co. analyst Michael Olson said in an interview from Minneapolis.

Napster controls about half of the online-music subscription market in the U.S., which amounted to $240 million last year, according to research firm Jupitermedia Corp.

Subscribers get jukebox-style access to 6 million songs for $12.95 a month. That differs from Apple Inc.'s iTunes, which sells song downloads for 99 cents each.

Napster began in 1999 as a free music-swapping Web site and sought bankruptcy protection in 2002 after record companies sued over copyright violations. Roxio Inc. purchased the company out of bankruptcy that year to start a paid download service and adopted its name in 2004.

AT&T Deal

Gorog, 55, is focusing on partnerships with mobile-phone carriers to expand his 760,000-customer base. AT&T Inc. began making the Napster Mobile music service available to 12 million wireless customers in June, offering song downloads for $1.99 each or five for $7.49.

``We expect a very significant increase in our mobile revenue in our fiscal year 2009, and this AT&T relationship will be a significant part,'' Gorog said in an interview. The CEO, a business-development executive at Universal Studios in the 1990s, owned 1.3 million shares, or 2.8 percent, as of May 31.

Napster's biggest direct competitor is Rhapsody, a joint venture of Seattle-based RealNetworks Inc., the maker of the RealPlayer for online media, and Viacom Inc.'s MTV Networks. Rhapsody may also be a potential buyer, Piper Jaffray's Olson said.

``We don't comment on M&A activity until there's something to announce,'' RealNetworks spokesman Bill Hankes said. The company's 2007 music revenue was $149.1 million, mostly from subscription services, he said.

`Pull the Trigger'

``RealNetworks could come in and add those subs to their subscriber base,'' said Olson, who recommends buying Napster shares. ``Given where the stock is now, it wouldn't surprise me if someone were to pull the trigger on a takeout in the next 6 to 12 months.''

Three analysts rate Napster ``buy,'' and five recommend holding. Canaccord Adams Inc. analyst Steven Frankel, based in Vancouver, British Columbia, says to sell.

``They solved the cash problem by not spending any money on marketing, but then you can't grow,'' Frankel said in an interview. ``Show me the revenue growth.''

Dissident shareholders, who are campaigning to replace three of eight board members, said Napster's value may be as much as $300 million, or $6.47 a share, based on acquisition prices of other companies, according to a June 26 proxy filing.

`Dubious Distinction'

``At today's valuation, Napster has the dubious distinction of being worth more dead than alive,'' according to the proxy signed by Perry Rod, 29, a Web site developer; Thomas Sailors, 49, an investor and former banker; and Kavan P. Singh, 29, owner of 10 Cold Stone Creamery ice-cream stores. The three owned 648,180 shares, or 1.3 percent, at the time of the filing.

The investors say lack of confidence in the company's governance is holding down Napster's value. Their filing points to CBS Corp.'s acquisition of the social-networking site Last.fm, which offers song downloads and free advertising- supported music, for $280 million in May 2007.

``We'll study it,'' Gorog said of the proxy. ``There are not any vacancies on the board.'' Three directors are up for re- election at the company's annual meeting Sept. 18.

``Napster is a very important strategic asset the market's valuing at zero,'' said Sailors, who added that his Dallas-based Cloverdale Investments LLC now owns 625,000 shares. ``You can buy Napster for less than its liquidation value. It's just a matter of time before people realize that.''

To contact the reporter on this story: Don Jeffrey in New York at djeffrey1@bloomberg.net.