Napster, Inc. Q4 2006 Earnings Conference Call Transcript (NAPS)

Napster, Inc. (NAPS)
Q4 2006 Earnings Conference Call
May 17, 2006, 5:00 p.m. EST

Executives:

Alex Wellins, Investor Contact, Blueshirt Group
William Christopher Gorog, Chairman, Chief Executive Officer
Nand Gangwani, Vice President, Chief Financial Officer

Analysts:

Kit Spring, Stifel Nicolaus & Company
Dan Salmon, Harris Nesbitt
Darren Aftahi, ThinkEquity Partners
Gene Munster, Piper Jaffray
PJ McNealy, American Technology Research
George Sutton, Craig-Hallum

Presentation

Operator

Good afternoon, ladies and gentlemen, thank you for standing by. Welcome to the Napster Fourth Quarter Conference Call. At this time, all participants are in a listen-only mode. Following today's presentation, instructions will be given for the question and answer session. Operator Instructions As a reminder, this conference is being recorded today, Wednesday, May the 17th of 2006. I would now like to turn the conference over Alex Wellins with the Blueshirt Group. Please go ahead.

Alex Wellins, Investor Contact, Blueshirt Group

Thanks for joining us on today's call. With me today are Napster's Chairman and CEO, Chris Gorog, and the Company's CFO, Nand Gangwani. Today, after the market closed Napster issued financial results for the fourth fiscal quarter. The earnings release in this conference call can be accessed from the Investor Relations section of Napster's website at Napster.com. We would like to remind you that during the course of this conference call, Napster's management will make forward-looking statements, including predictions and estimates.

These statements, including any statements regarding expectation for future cash balances, revenue, expenses, net losses, customer acquisition costs, the mix of advertising and subscription revenues, acceptance of the Napster services, including the Napster.com initiative and Napster Mobile; customer upgrades from Napster.com's service to the Napster subscription service, customer churn, the success of the Napster brand, Napster's ability to create value for advertisers, the growth of the web as an advertising medium, product development, interoperability of our service with increasingly available and popular hardware devices and cell phones, competition in the industry, relationships with content providers and strategic partners, international expansion and the growth of digital music sales as a whole, involve a number of risks and uncertainties.

Actual results may differ materially from any future performance suggested in the Company's forward-looking statements. We refer you to the Company's Form 10-Q for the quarter ended December 31, 2005, on file with the SEC for important risk factors that could cause actual results to differ materially from those contained in any forward-looking statements. We expressly disclaim any obligation to update this forward-looking information. With that said, I'll turn the call over to Chris.

William Christopher Gorog, Chairman, Chief Executive Officer

Thank you, Alex, and thanks to everyone for joining us today. Fiscal 2006 was a year of strong revenue growth, pivotal new product development and an expansion of our global footprint and strategic partnerships. Revenue totaling $94.7 million was up more than 100% year-over-year. Fourth quarter revenue was $26.8 million, up 54% over the prior year quarter. And as promised, due to very focused cost management, our operating expenses for Q4 were down significantly, as was our cash burn, and we exited the fiscal year with more than $104 million on our balance sheet.

We believe we have significantly improved our platform and strategic position over the past fiscal year. And more importantly, we have now created a much more cost effective way to build our business with the introduction of our new advertising supported free web-based music experience at Napster.com. I look forward shortly to giving you a more complete update; but before I do, Nand will give you our financial report.

Nand Gangwani, Vice President, Chief Financial Officer

Thanks, Chris. As Chris mentioned, Napster reported revenues of $26.8 million, up 14% from $23.5 million in the previous quarter. Excluding hardware promotions and license revenue, music revenue was up $3.5 million or 15% during the quarter due to strong seasonal subscriber growth. Revenues from international, including the UK and Germany, totaled approximately $3.4 million, or 13% of revenues for the quarter.

At the end of fiscal Q4 '06, Napster's total paid subscriber base was 606,000, including 59,000 university subscribers. Excluding university, the number of premium paid subscribers grew 16% from the third quarter of fiscal '06 and 54% year-over-year. Subscriber revenue, excluding one-time hardware revenue with BellSouth, grew to 87% of total revenue this quarter compared to 86% last quarter. We define subscriber revenue as revenues from both monthly subscription fees as well as downloads purchased by both paid and trial subscribers.

Gross margin for the quarter was 28%, up versus Q3's gross margin of 27%. The increase reflects the strength in overall subscriber numbers, and therefore favorable mix to our subscription-based revenues. Operating expenses for the quarter totaled $17.4 million, down from the previous quarter of $24.6 million, as we dramatically reduced broad-based advertising. It was also well below our guidance of approximately $20 million, as we moved some marketing programs relating to Germany and other projects from Q4 to fiscal Q1.

On a line item basis compared to the prior quarter, sales and marketing expenses decreased to $9.6 million from $15.4 million in Q3. R&D spending for the quarter came in at $2.9 million, down from $3.8 million due to lower personnel costs and reduced outsource development expense related to the new web-based initiative. Fourth quarter G&A was $4.9 million, down slightly from the last quarter. As explained last quarter, the loss from unconsolidated entity of $226,000 reflects our portion of the loss from a joint venture with Tower Records Japan. Net loss from continuing operations after income taxes for the fourth quarter was $7.3 million or $0.17 per share. Additionally, we had income from discontinued operations of $2.9 million. This income is related primarily to the settlement of purchase price adjustments on the sale of our consumer software division.

Overall, GAAP net loss was $4.4 million or $0.10 per share, favorable to our guidance due to the offset divestiture settlement as well as a significant reduction in marketing expense. Napster ended the period with 145 full-time employees.

Moving to the balance sheet, we entered Q4 with over $104.2 million in cash, cash equivalents, foreign currency conversion in transit and short-term investments. The $2.2 million investment in unconsolidated entity represents our net investment in Napster Japan and includes our second and final payment of $1.4 million or our 31% equity stake in the JV. Total cash and short-term investments, as defined earlier, decreased approximately $7.2 million from last quarter and reflects the collection of roughly $3 million of receivables on holiday prepaid card sales and an MP3 player bundling agreement with Trekstor in Germany.

Now to guidance. Due to the very recent launch of Napster.com, and the possibility that subscriber growth could slow initially as users experiment with the pay site, our visibility is more limited than usual. Given this uncertainty, we are currently estimating revenue for the first quarter of fiscal '07 to be in the range of $25 million to $28 million. We expect Q1 operating expenses to increase on a sequential basis to approximately $22 million. This increase is based on a one-time marketing spend related to Germany and one-time Napster.com launch marketing activities. We will also be expensing stock options and ESPP shares starting this quarter, which will account for approximately $1 million of increase. We are projecting net loss for the first quarter to be approximately $16 million, implying a loss per share of approximately $0.37.

To conclude my remarks, we ended Q4 with over $104 million in liquid cash and short-term investments and we continue to believe that we have sufficient cash to fund ongoing operations beyond the end of calendar '07. While we expect cash flow to fluctuate from quarter-to-quarter due to the timing of certain large collections and payments and periodic bumps in our marketing span from time to time, we are not planning for substantial increases going forward, and our focus remains on controlling expenditures and managing cash burn downwards over the long-term. We're very excited about the potential long-term positive impact of Napster.com to our financial model and believe that overtime we'll see a significant increase in monthly visitors, the infusion of advertising revenue, and a reduction in subscriber acquisition cost and subscriber churn. I appreciate your attention, and now Chris will bring you up-to-date on the launch of Napster.com and some other activities.

William Christopher Gorog, Chairman, Chief Executive Officer

Thank you, Nand. "Free music at home -- why, it's almost like the heyday of Napster." This quote from the Los Angeles Times pretty well sums up what we were indeed trying to do when we created the new free music service at Napster.com. So, we were delighted that the L.A. Times and so many others in the media got it. In fact, Napster offering free music was such a surprising and exciting story, our PR agency has advised us total impressions from this news event exceeded 90 million. But, we are even more pleased that music fans are getting it. In our first two weeks since launch, visitation to Napster.com has increased 133% over the prior two-week period, increasing our visitation even beyond our Super Bowl levels.

Our Napster links tool immediately got picked up by the Internet music community, and free Napster music links are beginning to sprout up around the web. And fans are discovering the Narchive and beginning to contribute to the people's history of music. Napster.com, Napster links, and the Narchive were designed to work together to create a viral effect to drive visitation and in turn drive upgrades to subscription and increase track purchases. In our first two weeks, we were very pleased to see little or no evidence of paid subscriber defectors to the free service, as our paid subscribers seem to quickly understand the value of remaining a subscriber. We were also very pleased to see robust track sales over the last two weeks, up 15%, which we think is particularly notable since the 5 plays per track limit has not really begun to kick-in for the most part.

This begins to provide important evidence that the more sampling and playing, the more transactions. Although it is quite early to draw conclusions, these preliminary results are very encouraging to us. From the perspective of our paid subscription business, the key thing to understand about Napster.com is we believe it’s viral potential to drive visitation will help us to significantly lower our subscriber acquisition cost. We are in the process of substantially reducing our cash burn and working to accelerate our drive to profitability, and believe we now have a very important tool to help us with this critical goal. As free Napster content becomes more pervasive on the web, more and more users should come to Napster directly without requiring the high levels of paid advertising we used to jump-start our business.

Those visitors will discover the excitement of Napster's unlimited access model and freedom from 30-second clips, and we will initially monetize that traffic via advertising. We believe that over time, many free users will become interested in trying our subscription service. And what should emerge is a much more informed customer and a customer that is much more likely to stay with our service for a longer period of time. Lowering SAC, decreasing churn, increasing the lifetime value of our customers, are key goals of Napster.com. While the free music experience at Napster.com has certainly been designed in part as a marketing tool for our paid music products, we also believe we have created the foundation for an important stand alone media property on the web.

While there are a number of music-related experiences on the web today, it's pretty clear no one yet owns this turf. Like say, ESPN owns sports or Google owns search. We know what we do own is the most well-known music brand on the web. And it is now our challenge and our opportunity to leverage this great asset to the next level by building out a comprehensive media property that creates value for advertisers. One-third of media consumption is occurring on the web today. Really an extraordinary statistic; and yet only 6% of ad dollars have thus far migrated to the Internet. Companies that can add substantial value to sponsors can create a lot of value for themselves. We think Napster is in a special position to address this opportunity. Everyone loves music, and advertisers love to have their brands associated with music. We can help.

Although we do not ask personal information from our visitors to Napster.com, we can still tell a lot about them, which enables us to add value to advertisers through refined targeting and by creating more relevant contextual messaging for users. We'll define our success with the ad model by creating real value to sponsors and exciting and personally relevant experiences for our free users. Although we have just begun our ad sales efforts, the reactions we have received from advertisers and media buyers has been not only very positive but also very interesting. Advertisers seem to be equally interested in Napster for what we are not as much as for what we are. A common theme amongst advertisers and media buyers has been that they're looking for a music environment that is not just part of an overwhelming generic portal, and one that is not solely based on free form user generated content. They are looking for a quality environment for their brands and one where their brands can stand out and also create an affinity with certain types of music and fans.

There has also been a great deal of interest expressed by sponsors and simply associating with the Napster brand itself. We are very encouraged by the response we are getting from advertisers. It's exactly what we had imagined. And our sense is, we seem to be arriving on the web-advertising scene at the right time. As billions of ad dollars are migrating to the web, we're excited that world-class brands see Napster as a place they want to be.

So, in summing up the launch of Napster.com, we believe that advertising revenue will grow to become a material contribution to our sales over the next year, and simultaneously substantially drive down our subscriber acquisition cost. We will continue building out our new web experience for music fans. Although we feel we have made a great start, it's just that; and we're excited to continue adding features, new functionality, and in particular, new ways to involve the music community.

Now, as we look forward to fiscal 2007 and as we build value through new synergies created by Napster.com, there will be another very significant growth driver to keep your eyes on. Motorola, Nokia and other key global handset manufacturers, will now begin to ship Windows Media Audio portable subscription enabled cell phone MP3 players, and will quite literally be shipping tens of millions of these units over the next 12-24 months. Needless to say, we knew this day would come. We are extremely pleased it is finally on the way. It's nice when the cavalry is a global ecosystem of multi-billion dollar company, all of which believe they can add value to their customers by supporting WMA portable subscription technology.

This phenomenon, together with the growing WMA MP3 player install base -- and very importantly, more seamless interoperability of these devices with services -- will dramatically increase our addressable market for portable subscription. We think Napster in particular should receive substantial benefit from this trend, as we are one of the largest users and issuers of Windows Media DRM in the world.

Turning now to Napster Mobile. Our partnership with Ericsson gives us unique opportunities to get in front of key handset manufacturers and wireless carriers throughout the world. We recently announced our first carrier deal with SunCom, and believe this agreement will be the first of many to come. Napster Mobile should get substantial traction over the next year with our comprehensive wireless offering, which includes side loading opportunities, over the air downloads and wireless subscription with dual delivery to the PC.

Napster's complete control over our technology platform continues to enable us to move very quickly, and we intend to be a cutting-edge leader in wireless, providing exciting music products to carriers around the world. Our international operations continue to make an important contribution to our growth, and Napster Germany has recently been piling up awards in this tech-savvy territory, including the very influential CHIP Magazine, awarding Napster Best Music Download Service, above itunes and all other competitors in Germany. The UK continues to extend its strategic partnerships, and Napster Japan remains on track to launch in 2006. This will broaden our reach to the top four music territories in the world.

So to conclude my remarks, we are pleased with our initial growth, but believe that going forward we now have a more balanced and cost-effective approach to addressing the digital music opportunity. Our products now create revenues from advertising, subscription, downloads and wireless offerings. Our strong strategic partnerships with XM and Ericsson, together with our growing international footprint and an infrastructure that is the envy of our competitors, continues to position Napster very well during these early rounds. With only 5% of recorded music thus far being sold digitally, the game is clearly just beginning, and we believe we have a very valuable seat at the table. Thank you for your attention, and now it's time for your questions.

Questions & Answers

Operator

Operator Instructions. And our first question comes from Kit Spring with Stifel Nicolaus. Please go ahead.

Q - Kit Spring

Okay. First of all, can you just talk about big picture -- do you think you can make money on a standalone basis in the subscription business and how many subs you need to break even? And talk about -- maybe secondly -- about why you think wireless operators will cut you in to the deal and let you guys participate instead of doing it on their own, thanks.

A - William Christopher Gorog

Sure, Kit. Okay, so in terms of making money in the subscription business, we have a lot of confidence that we will. I'm sure you're familiar with the fact that we haven't given out specific guidance as to when we believe breakeven will occur, but clearly we think we're making a lot of progress on our model and bringing, I think, new health to our model. The most significant cost in our model that we have control over has been our marketing expenditures. And I think that, you know, the key levers for us is reducing subscriber acquisition cost and improving retention, and I think that as we spend some time in the script today, we do believe that the Napster.com product and really synergy with our core subscription business is going to prove itself to be a very, very effective way to very efficiently gather customers, educate them about what a subscription is, and then again, make for a more informed subscriber, you know, thus really ending up with, I think a much stronger retention.

We've already done a lot of really good work on churn; we have very substantially reduced our turn over the last 12 months. We have even reduced our churn incrementally over the last two weeks, which is quite interesting with the launch of Napster.com. So, I think with all of those things working together, I think that there can be a very good business built around subscription. And I think also the symbiosis now with the advertising revenue is a very healthy model, and which is a nice sag way to your question about wireless. You know, we're really genuinely excited about the wireless opportunity. There's no question that some of the bigger carriers and some of the bigger regions are making some efforts to do this themselves, obviously. But there are many, many more carriers in the world with, quite literally, addressable market in the hundreds of millions, that have absolutely no interest in trying to do this themselves.

And they're looking for not only integrated technology solutions from ourselves and Ericsson, but also branded solutions so they can go into their markets and say here's Napster Mobile. This is a cool upsell for them. So I think that -- I think the fact that I think you'll see many, many -- again, in the hundreds of millions in terms of the addressable market -- in the second and third tier mobile carriers reaching out to third parties; and secondarily, I think you'll find some of the big boys discovering how complex this is. And I think we're already seeing some evidence that some of the larger carriers have waived off an effort to do this themselves. So, I think all of that together encourages us that this is a very real opportunity.

Q - Kit Spring

Thanks, and can you just remind us where you are as far as your traffic goes on Napster.com – up a 133%…

A - William Christopher Gorog

I think we rolled out of April with 1.9 million visitors; and as we said that increased during the first two weeks since our launch by 133%. So, that's the precise metric.

Q - Kit Spring

Okay, great, thanks, that's a nice increase.

A - William Christopher Gorog

Thank you, Kit.

Operator

Thank you, next question comes from Dan Salmon with Harris Nesbitt. Please go ahead.

Q - Dan Salmon

Hey, guys. Very nice quarter, two quick questions. The first, I know they only went on -- the new Samsung and Pioneer devices only went on sale recently, but can you tell us if you've seen any significant uptick in the takeup rates at the XM plus Napster product yet? And just the second question, you mentioned some work you may be doing with the music community for promotional purposes. Just any additional insight you could give us there would be great. Thank you.

A - William Christopher Gorog

Sure, Dan. In terms of XM, I believe the Pioneer devices have just very recently shipped, the two devices from Samsung have not shipped yet. I think that sort of any day. So unfortunately, it's definitely too early for us to give you any report on what the uptake is there. But I would just expand a little bit in terms of what we're doing with XM. These players are all being shipped with installation CDs that prompt the user to download the XM plus Napster client. So, the client software that they're using to manage their experience on this device includes Napster. It also includes a 30-day free trial and 5 free download so, you know, we're providing some good incentive and some good inbox marketing and on CD marketing. So basically, there's no way for the customer to enjoy the benefits of the device they've purchased without managing the process within the XM plus Napster client. So, we think that we're going to, you know, basically, I guess almost close to 100% hit rate of these purchase devices in terms of people being brought into the Napster environment; and then, of course, our job is to encourage them to subscribe and purchase downloads. So, we'll see how that goes.

We are, you know, very excited about the model in general. As I've mentioned in the past, to -- you know, for the power music fan that is really trying to bring all of their digital world together, this is going to end up being the most comprehensive and I think most exciting music experience out there. So, we think that overtime it's going to create a lot of excitement. In terms of my comment about further development on Napster.com, you know, we are, you know, just super excited, frankly, that we were able to get out there with what I would hope people view as a provocatively different and exciting music offering, to be able to take the Napster brand and couple it with a free music offering, which is very exciting. I mean, quite literally you can listen to any song out of 2 million songs on-demand any time you want with only this 5-play limit per track, you know, goes way beyond a marketing gimmick. And I think that, you know, the visitation to the site thus far really suggests that this is a pretty cool experience in and out of itself. So, I really can't imagine a way that we could have created a free web based service -- ad supported service that would have created more excitement from the sort of opening gun. And I just think it's a wonderful place for us to start. That said, some of the efforts we've made with the creation of Napster links, certainly the building out of the Narchive, will suggest to you directionally where we're trying to go with this.

We are very much thinking about web 2.0 and creating a very open environment, a very open platform. You know, already we're starting to see Napster links, you know, on MySpace and on UCLA Jazz Blogs, you know, we really want to create an environment that actually is much more expansive than our own URL. And so, I think that what we're going to be focusing on in terms of the music community is, frankly, just creating more and more tools and ways for them not only to enjoy music experience at our URL, but to power their own experiences, as well.

Q - Dan Salmon

Great, thank you very much.

A - William Christopher Gorog

Thanks, Dan.

Operator

Thank you, next question comes from Darren Aftahi with ThinkEquity Partners. Please go ahead.

Q - Darren Aftahi

Hi, guys. Just a couple questions. First one, housekeeping, on operating expenses for the forthcoming quarter, you said they're going to rise to $22 million. And then you’ve mentioned a one time marketing spend in Germany and Napster.com. And did I hear correctly you said 1 million in stock compensation expense in that number?

A - Nand Gangwani

That is correct. On operating expenses, we'll be going up about 4 - 4.5. About half of that comes from these one-time marketing expenses, which are programs that we originally planned to do in the March quarter, but decided it would be more effective to do it this quarter. And the other half 1 million dollar comes from stock-based compensation. And the other -- half of the second half comes from one-time year end activities, like agency filing fees, benefits consulting, and year end bonuses and so on.

Q - Darren Aftahi

Okay. Great. And then, two questions. Chris, in talking about the Napster links, I was curious if you guys were able to track sort of how people were virally passing links along. Give a sense for -- is it via IM, email or blogs? And the second question relates to wireless. It seems as though the premise of the wireless opportunity is predicated on both -- the networks being up and device is being able to handle true subscription. Are we going to see that in overseas markets before we see in the U.S.? Or what's kind of your take there?

A - William Christopher Gorog

Yeah, great questions, Darren. In terms of the Napster links, we have the infrastructure in place, I think, to do a more comprehensive job of tracking how this is being used. You know, right now, the most rudimentary thing we can track is how many times people click within the player on “Share It” and creating e-mails to share music, which is happening quite a lot. I don't have any statistics for you today, but that's becoming quickly very popular. We have really sort of searched the blogosphere and we're starting to see the Napster links pop up in a lot of different interesting places, including some major blogging sites. I mentioned MySpace, some special interest music sites. So, you know, at least preliminarily, we're seeing it across all of those areas you mentioned. And, you know, I think going forward we'll try to understand better, you know, what's -- you know, what the applications are and see how we can, you know, continue sort of prompting that viral opportunity. In terms of your wireless question, a great question on the networks. There's no question that Asia and Europe are ahead of the U.S. in terms of the -- what the wireless networks are capable of. And I think you will likely see over the air subscription, our first customer being outside of the U.S.

Q - Darren Aftahi

Great. Thank you.

A - William Christopher Gorog

Thank you, Darren.

Operator

Thank you. Next question comes from Gene Munster with Piper Jaffray. Please go ahead.

Q - Gene Munster

Hey, good afternoon. And one of the things -- you might have touched on this, Chris, in you remarks, but I missed it. In terms of the massive increase you guys had in traffic once you launched Napster.com, what was kind of the carry through to actually new subscribers? If you can just recap what your comments were on that.

A - William Christopher Gorog

Well, I think that the one thing that I think was very notable Gene, from our perspective is, churn did not increase. So, we did not see any discernible defection from our current subscriber base. That was very, very important to us. In fact, over the last two weeks, churn incrementally went down a little bit, which was quite interesting. So, I think that the most accurate thing I can say in terms of what happened over the last two weeks is nothing remarkable. So, no increase in churn; and correspondingly, there was no great increase in subscriber ads, either. Now, the latter does not surprise us because, you know, we really designed this thing with the idea that it would be a slower sell, but a -- ultimately, a better customer that would be educated. So, I think that, you know, part of the magic, if you will, of the way this thing has been designed is people will first understand how unlimited access works, that it's no longer 30-second clips and gee, do I have to buy a download? So they'll get that; they'll be gently promptly -- or prompted and educated about why it's cool to upgrade to subscription. Certainly portability to unlimited downloads to your MP3 player is going to be the key theme, but there are other themes like CD quality and so forth.

And I think the combination -- frankly, what we're hoping in the early days is the combination of, you know, much stronger visitation together with decent conversion of those visitors will, you know, create over time a much more robust subscriber base and a much more efficient way to gather customers. The one thing, again, if you missed my prepared remarks that I also found very interesting, is in this environment of free plays on demand, we actually increased track sales over 15% in the first two weeks. So, all in all, we're delighted; but, you know, it's just so early, I think we have to see how this thing shakes out. I think in a general way, we have the confidence that providing unlimited sampling and virtually unlimited playing is a -- there's no better way to wet people's appetite. Our frustration, frankly, over the last two years has been, you know, how do you tell people about how cool subscription is? Because it's very difficult to do in paid advertising; it's, you know, you're fighting the whole sort of buy verses rent metaphor and so forth. But the one thing we've always known is as soon as you sit somebody down in front of the PC and you show them Napster, they go crazy, they love it. So, this is a way to do that. And we have a lot of confidence that over time it's going to work really well.

Q - Gene Munster

Yeah, no, it makes sense. One just quick follow-up. You talked about visitation and as you know, the visitation -- significantly here. What's just big picture -- the plans to keep the visitation up and running? Maybe just -- I've seen you've done marketing on, like, you know Ticketmaster and MySpace and so forth; is there any kind of big areas you guys are going to be keeping the marketing heat on to keep the visitation up?

A - William Christopher Gorog

Okay, well. This is a great question. I would say a couple things. Specific to your direct question, we will continue to be doing web-based advertising. So, we will, you know, be all over the web at the sort of customary places that we have been advertising, prompting people simply to visit Napster.com and enjoy a free music experience which, you know, is a great value proposition -- it's a lot easier sell than go to Napster and buy something. So, that's great. And so I think we've got a really great, a very attractive message and a much clearer value proposition. So, we'll continue doing that. But, you know, honestly, we really have to focus on the viral nature of this product. And, you know, a free music experience in and of itself should be very viral. It's pretty hard to find objection to that. And so, I think that word of mouth should really help us here. Obviously, we really do hope that the Napster links become very pervasive across the web; and of course, we'll continue building out community with Narchive and so forth. But the viral nature of this is very, very important. So yeah, we'll continue paid advertising on the web for sure. We will support it. But I think we've really got to have confidence in the product that we built and expect that people will be talking about it and encouraging their friends to go to Napster and enjoy the service. Now one thing that I'm extremely pleased to be able to tell you is we haven't seen any degradation over the last two weeks. You know we've seen a very -- obviously, our first two days were spectacular, and then we dropped down to, you know incrementally a smaller level. But that level has stayed constant and it's building. So, that's really good news for us. And I -- looking forward to just seeing how we can continue to build that.

Q - Gene Munster

Great, thanks.

Operator

Thank you. Next question comes from PJ McNealy with American Technology Research. Please go ahead.

Q - PJ McNealy

Hi, guys. Good afternoon. You talked today about the huge numbers of -- spike in ad traffic to Napster.com. Does this mean that we should now see the advertising revenue kick in the June quarter and that will be reported as a broken out line item this quarter?

A - Nand Gangwani

In terms of -- whether it's going to be broken out this quarter, it will not be broken out this quarter. We may decide to do it towards the end of the year when it becomes the material portion of our revenues; and with respect to the first question, I'll hand it over to Chris.

A - William Christopher Gorog

Yeah, P.J. I'm not sure what your first -- will we report it separately, and no we won't; and what was the other part of the question?

Q - PJ McNealy

That was actually the first -- that was the first question. The second question was now, did I hear you correctly say that subscription growth could slow because of the Napster.com initiative this quarter?

A - Nand Gangwani

As Chris pointed out, we are still unclear in terms of how long it will take to convert the unique visitors into subscribers, because now they've got to experience the free website, the free experience, and then over time we'll upsell those guys. So, we don't know exactly how long it will take; and from a conservative perspective, we are planning that it will probably take a little bit of time. But the good news is we'll get qualified visitors, enhance their churn should go down over time pretty dramatically.

Q - PJ McNealy

Got it, and then just one last question about gross margins. Obviously, they came in obviously positive fashion this quarter. As we think about gross margins moving forward, should we expect them to trend back down here because you're now paying the music labels, you know, for each of the free plays that you're getting through Napster.com?

A - Nand Gangwani

Yes, in terms of the content royalties, the structure is pretty similar to the higher margin subscription revenue royalties that we share with the labels. So, we do think over the long-term that the gross margins will increase. We normally don't guide on the gross margins on a quarterly basis but you could see some compression because we'll be amortizing the N.com development expenses that we've capitalized, which will hit our cost line. And so that may depress it. But as the revenue ramps up, we should get back up again.

Q - PJ McNealy

Got it. Okay, great, thank you.

Operator

And our last question comes from George Sutton with Craig Hallum. Please go ahead.

Q - George Sutton

Hi, guys. Three questions. If you believe as I do that the great limitation in your business has been the lack of compatible MP3 devices, it seems to be a major component in the issue and opportunity, can you give us a picture as to what the manufacturers have shared with you regarding the fall launches of new devices and how integrated they will be with Napster?

A - William Christopher Gorog

Thank you, George. Yeah, I think a couple of key points about that -- extremely important question. And I really should have highlighted this in my prepared remarks. I think one of the -- the really exciting things to us over the last few months has been seeing some of the new MP3 player products. I would immediately point for example, to the Samsung Z5, which comes in 2 gig and 4 gig flash memory. This is a beautiful device that hit the market a number of weeks ago. Best Buy has told us it's selling extremely well, as Samsung has -- it is, frankly, very NANO like. This is -- I think, Samsung actually went out and hired the industrial designer and the guy who built the UI for the NANO. And you know, you finally pick up a WMA device that you put in your hand and you actually say this is great. And not only does it look great, it operates extremely well. I've been using it for the last couple of months and I have had a bullet proof experience with it out of box with Napster To Go. So, we just simply couldn't say that 6 months ago or 12 months ago. And so I just think that's a huge, huge difference.

I know that there’re other devices out there from other manufacturers, all of which are coming online, many of which that we have personally tested, and I'm very excited about it. Because, we're in a position now to know that our customers are going to be having a very successful experience with what we have always felt was a killer app function. That is, portable subscription versus individual a-la-carte download. So, one of the things that I think we've talked about before that I've always found kind of extraordinary, is that although we have teased you a little bit about this, have not reported the percentage of our subscribers that are Napster To Go subscribers, it's quite high, and very much higher than our competitors. One of the reasons is that our technology with portability has worked better than theirs have. And when I think of our subscribers that to some degree have had to suffer through some of these early adoption days with hardware that really was not bullet proof, what I see there is a really strong desire for the model. And that is very exciting to me. So, I think when you think about that and you think also about what is going to be happening now with the cell phone MP3 player hybrids with basically this entire ecosystem moving over to support WMA again, I really think it would be a mistake not to focus on that. Again, you could not have said this 12 months ago. 12 months ago the wireless carriers were fighting it, the handset manufacturers were fighting it. They basically have all joined the WMA camp now, they're all moving towards this. And this is going to be very significant for us.

Q - George Sutton

Okay, thank you. And I wanted to ask about SunCom. They have a million subs. Can you walk us through how the Napster service will be offered to a SunCom customer? You know, will it be offered as a separate line item on the bill, and which of the phones will actually work with, if you could just walk through that, that would be great.

A - William Christopher Gorog

Yeah, the SunCom deal will launch end of June. The details as to which handsets we have not made public and SunCom has not made public yet. They will be marketing Napster, obviously, to their million subscribers in the Southeast. I think the key thing for from our perspective in terms of this deal is, this is not a side loading deal. This is not a, iTunes, Motorola side loading deal, this is an over the air, download purchase wirelessly delivered to your cell phone and simultaneously delivered to your PC. We are the first in the United States -- the first third party company to do this. And I think that's what we're super excited about is it's a proving ground for us to bring this product out and like each one of our incremental steps in the wireless side, this gives us the ability to show it to not only other carriers in the U.S larger carriers, but also people in Europe and Asia.

Q - George Sutton

Okay. Last question for Nand. You mentioned you have capitalized the development of the Napster.com. Can you walk through how much you've capitalized and what your amortization accrued will be? Thanks.

A - Nand Gangwani

Yeah, right now we've capitalized close to $3 million and we'll have amortized it over a three-year period.

Q - George Sutton

Great. Thanks, guys.

Operator

Thank you. Management, I'm showing there are no further questions. I'll turn the conference back to you for any closing comments.

William Christopher Gorog, Chairman, Chief Executive Officer

Thank you very much, we'll see you next quarter.

Operator

Thank you, ladies and gentlemen. That concludes the Napster fourth quarter conference call. We thank you again for your participation, and at this time you may disconnect.

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