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Napster, Inc. (NAPS)

Q1 2007 Earnings Conference Call

August 2, 2006 5:00 pm ET

Executives

Alex Wellins - IR

Chris Gorog – Chairman & CEO

Nand Gangwani – VP, CFO

Analysts

Kit Spring - Stifel Nicolaus

Gene Munster - Piper Jaffray & Co.

Lee Westerfield - BMO Capital Markets

George Sutton - Craig-Hallum Capital Group

Barbara Coffey - Kaufman Brothers

PJ McNealy - American Technologies Research

Ingrid Ebeling - JMP Securities

Darren Aftahi - ThinkEquity Partners

Presentation

Operator

Good afternoon, ladies and gentlemen. Welcome to the Napster first quarter conference call. (Operator Instructions) At this time I'd like to turn the presentation over to Alex Wellins, Blueshirt Group, please go ahead, sir.

Alex Wellins

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 its first fiscal quarter. The earnings release referenced in this conference call can be accessed from the Investor Relations section of Napster's website at Napster.com as can a webcast of this call.

We'd 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 the expectation for future cash balances, the launch of Napster service in Japan, the launch of Napster Mobile, current and potential relationships with wireless carriers and strategic partners, the availability of music-enabled cell phones and Napster's interoperability with these phones, revenue, the impact of the ad-supported service on subscriptions as well as sales and marketing expenses, seasonality expenses, net losses, subscriber conversion rates and churn, and the success of the open platform model for digital audio devices, 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 10Q for the quarter ended June 30, 2006, 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.

Chris Gorog

Thanks, Alex. Thanks, everyone, for joining us on today's call. Our financial results are highlighted by strong revenue and a continued decrease in our cash burn. The first quarter was very busy operationally as we rolled out the new Napster.com, released a significant upgrade to our portable subscription product, and made important progress on Napster Mobile.

Revenue grew to a record $28.1 million, up 34% over the prior year quarter, and up 5% sequentially. Net loss for the quarter was $9.6 million before taxes, and we delivered on our commitment to reduce our cash burn which decreased to approximately $6.3 million.

Napster ended the first quarter with a total of $98 million on its balance sheet, providing us ample time and flexibility to execute on our business strategies including further development and refinement of Napster.com and the continued expansion and development of our Napster Mobile products.

The new Napster.com ad-supported, free music service is off to an encouraging start as we saw a 50% increase in monthly visitation, and averaged 60 million page views at the end of the quarter. Advertisers immediately understood the value of an association with Napster and our unique audience, and world-class brands such as Disney, Toshiba, Nextel and even the Navy have joined us since our launch.

Napster Mobile made very significance progress this quarter, and we're pleased to confirm today our alliance with NTT DoCoMo, Japan's largest wireless communications company with over 50 million subscribers. Masao Nakamura, CEO of DoCoMo recently said in The Japan Times, "Napster will take a very important role in DoCoMo's music service strategy, and I have great expectations for this new project." Well, we do as well.

Our alliance with DoCoMo is the result of their recent controlling investment in Napster's Japanese joint venture partner, Tower Records Japan. Napster Japan is on track to launch this Fall starting with a PC-based service. You should note that DoCoMo has publicly announced that its handsets will support Windows Media audio and, therefore, will be Napster To Go compatible. We can not disclose any additional details about our launch today, but we are very pleased to be partnering with Tower Records Japan, the country's largest music retailer, and now DoCoMo, the largest mobile communications company, as we prepare to launch in Japan the second-largest music market in the world. And, a market that is on the cutting edge in adopting new wireless entertainment products.

Continuing on the wireless front in the United States, Napster Mobile will officially launch next week with Suncom, a leading southeast regional carrier, offering the largest music catalog available anywhere on a mobile platform, with over 2 million tracks. Suncom's launch of Napster Mobile will include an extensive marketing campaign including point-of-purchase displays at retail, supported by significant TV, radio, and print advertising. This product, the first of its kind in the US from a third-party brand, includes over-the-air downloads and simultaneous dual delivery to PCs.

We believe that Napster remains considerably ahead of our competitors in mobile music, and we will have the opportunity to prove this again this fall when we announce another top tier global carrier.

Analysts now project that music-enabled cell phones will dwarf the install base of MP3 players over the next few years. So we believe our deep focus on mobile provides us with the opportunity to add a significant new dimension to our business. I'll return to my remarks on operations shortly, but first Nand will walk you through our results and our guidance.

Nand Gangwani

Thanks, Chris. As Chris mentioned, Napster reported revenues for the first quarter of fiscal '07 of $28.1 million, up 5% from $26.8 million in the previous quarter. This included $1.9 million of one-time revenue from prepaid gift card breakage. Revenues from international including, UK and Germany, totaled approximately $3.9 million or 14% of revenue for the quarter.

As of June 30, 2006, Napster's total paid subscriber base was 512,000. This includes 4,000 university subscribers, down from 59,000 last quarter, as each year Napster university subscribers fall off during the summer months. Excluding university, the number of paid subscribers grew 26% year-over-year but decreased 7% from the fourth quarter following the launch of the free music service.

While unique visitors grew significantly, the conversion of unique visitors to trial subscribers declined as expected, due to a longer sales cycle. We're actively working on making significant changes to the registration and upsell process to improve the conversion ratio.

Gross margin for the quarter increased to 32% in Q1 from 28% in Q4 and reflects the one-time benefit from prepaid card breakage. Excluding breakage revenue, gross margin was 27%, down 1% versus Q4, reflecting increased royalty rates for the Napster To Go product line.

Operating expenses for the quarter totaled $19.4 million, up from $17.4 million in the prior quarter, but below our guidance of approximately $22 million, as a result of controlled marketing spend. On a line item basis, compared to the prior quarter, R&D spending remained flat at $2.9 million.

Sales and marketing expenses increased to $10.5 million from $9.6 million in Q4, as a result of marketing related to the launch of the free service and the final phase of broad-based marketing in Germany.

First-quarter G&A was $6 million, up from $4.9 million in Q4, due to professional fees, and expensing of stock options as we adopted FAS 123 R this quarter.

As explained last quarter, the loss from consolidated entity of $330,000 reflects our portion of the loss from our joint venture with Tower Records Japan. Since we had no income from discontinued operations, both net loss from discontinued operations after income taxes and overall GAAP net loss for the fourth quarter was $9.8 million or $0.23 per share, favorable to our guidance of a loss of $0.37 per share.

Napster ended the period with 146 full-time employees.

Moving to the balance sheet we ended Q1 with $97.8 million in cash, cash equivalents, and short-term investments.

Now to the guidance. During the September quarter, while we expect improvements in all our key metrics, given the transitional impact of the free service and conversion ratios, as well as typical seasonality, we currently anticipate quarterly revenue of approximately $25 million.

We expect fiscal Q2 operating expenses to be lower than Q1 since the viral nature of Napster.com enables us to reduce sales and marketing expenses and continue our focus on expense management. We are projecting net loss for the second quarter to be approximately $12.5 million, implying a loss per share of approximately $0.30.

We do expect to return to strong revenue and subscriber growth in December and March quarters, not only because of seasonality, but also because we expect to have worked through the transitional issues related to the new free service, and we do expect to end fiscal '07 with solid, year-over-year revenue growth.

I appreciate your attention. Now Chris will bring you up to date on the launch of Napster.com and some other activities.

Chris Gorog

Thanks, Nand. I'll start out with a report on Napster.com. As I said in my introduction, the free ad-supported service has seen substantially increased visitation since its launch on May 1. Users are finding the site on their own, through online advertising, via search engines, and through our new Napster Links tool.

We're receiving approximately 3 million unique visitors per month, and are now averaging over 60 million page views per month. Users are spending about 20 minutes on the site per visit, and we are streaming over a half a million songs per day.

Advertisers have responded to our metrics and our audience by paying very attractive CPM rates for our display ads and video preroll. The fundamental goal of the free service, in addition to generating advertising revenue, was to increase our visitation while at the same time enabling us to spend less on advertising, and to attract better qualified subscribers and therefore, increase retention. Thus far, we have substantially increased visitation, are projecting significantly less advertising costs going forward, and are already experiencing reduced churn.

While we expected a negative impact to our subscriber growth during this transition phase, it's clear our bias towards creating a great, free experience and a great ad sales property put more pressure than we would have liked on the process of converting visitors to paid subscribers. Therefore, we are making important adjustments and have already implemented significant changes to restore better conversion ratios.

These changes include creating a new landing page for first-time visitors to Napster.com, which now offers the paid service upfront and explains its attributes and contrasts it with the free service. We have also instituted a variety of changes to our registration path and made further adjustments to the free service, all of which should get us back on track with healthy conversion.

We are confident we can achieve a better balance between our free and paid service going forward, and expect to return to add a substantial amount of new subscribers in the second half of the year, benefiting not only from our new adjustments but also a return to our strongest selling season.

As we look at our paid subscription business, we believe there are some significant reasons for optimism for the overall health and future of our paid business. The first I mentioned at the top of my remarks, and that is the very fast developing ecosystem of music enabled cell phones. With companies such as Motorola, Nokia, DoCoMo and many others which have confirmed a Windows Media Audio platform for music. There seems no doubt at this point that tens of millions of these devices will now be addressable by Napster over the next year, and that should prove very significant for us.

Napster basically will move from having an almost irrelevant addressable install base of music players to a nearly ubiquitous addressable base over the next few years.

If you take nothing else from this call today, that is what we hope you will remember. We believe this is the single-most important point in understanding the upside for our Company. The lack of a powerful, ubiquitous, device ecosystem has been the single most significant blocker to our growth, and it is now becoming unblocked.

We are also making significant progress in improving our service. We released an important upgrade to our paid service this quarter, with our proprietary Power Sync technology which substantially improves the portable subscription experience. While one of our key competitors has commented that the market was not ready for portable subscription, due to our committed focus on improving and marketing the portable subscription experience, 75% of our new subscribers over the last 12 months have opted for Napster To Go, our most expensive and exciting product.

So when we consider the entry of this powerful ecosystem of music-enabled cell phones together with our very strong uptake for Napster To Go, and then consider that we have reduced our subscriber churn by over one-third over the last 12 months, we conclude that our persistence and patience will be rewarded by remaining focused on what we believe is the best value and most fun for consumers.

Two notes before concluding my remarks and turning it over to Q&A. The first is, we've all read about Microsoft's so-called iPod killer and music service. Some comment that they may even deploy a closed system. Our view on this is that battles between closed platforms will only further reinforce the necessity for an open one.

We believe the long-term winners in this space will be the companies that stay focused on the consumer, which leads you to an open, shared ecosystem with interoperability between all services and devices, offering consumers the power and the choice. This is what consumers want, this is what the labels want, and this is what the artists want; and this is why we remain focused on the open system.

In the meantime, Microsoft has recently restated to us its strong support of the WMA platform and its continuing commitment to support Napster.

Lastly, since we receive questions about our view towards M&A from time to time, I'd like to address the question here. We do not have our heads in the sand regarding a possible merger or acquisition.

Senior management and the board are keenly aware of our strategic position and are vigilant and proactive in examining opportunities for our shareholders. We continue to receive a lot of interest in the Company and would like to assure our investors that we will always carefully weigh any value creation alternatives against the opportunity and risk associated with continuing as a stand-alone company.

We believe we have created substantial value that is not reflected in our share price and it is our number one priority to release that value through the execution of our business plan or by aligning with a strategic partner which we will always consider with seriousness as we represent our shareholders. Thank you for your attention today and now to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question will come from Kit Spring - Stifel Nicolaus.

Kit Spring - Stifel Nicolaus

Hi. Can you tell us what you might do if Microsoft did go to a closed system as far as a digital rights management solution for your portable product? Can you give us some rough ranges of what the cash burn for the fiscal year might be?

Chris Gorog

Thanks, Kit. I'll take the first one, and Nand will address cash burn. Well, first of all, I would say that I think it's quite unlikely that Microsoft will abandon the Windows Media audio platform and their DRM. Specifically, they have told me that they are not doing that, and I think if you just think it through intellectually, I think it's still very important strategically for their company to support a hardware and software ecosystem, to support their platform.

Now whether they go off to the side and try to create a closed experience and have Windows Media Audio with some additional bells and whistles to close other hardware players out or something to that effect, that is a different issue. I think the more threshold issue is, will they continue supporting Window Media audio and the platform? I think they will, and they have said they will.

Now, that said, I would quickly tell you that in I think what is a pretty remote case in our view, that they actually abandoned their platform all together, I think that it is pretty clear that there's a number of candidates that would rush in to try to play the role as the ubiquitous open platform.

You have OMA out there, the Open Mobile Alliance, you've got Marlin out there from Sony. We are currently compatible with WMA obviously. But also OMA, AAC, Cleartex MP3. So our technologies have already been built to be highly versatile and really DRM agnostic. While we believe there is a tremendous amount to offer from the WMA platform, we are far from dependent on it. So overall, we don't really see this having any impact on us.

As to the cash burn issue, Nand, do you want to take that one?

Nand Gangwani

Kit, as you know, we don't guide specifically on the cash burn going forward, but as you heard in a call late last year, we committed to a substantial reduction in the cash burn, and we have executed I think very well on that front, as you've seen. We continue to remain committed to the cause of reducing cash burn over the longer term, getting to profitability. So I think I'll leave it at that.

Kit Spring - Stifel Nicolaus

Could you give us an update, you mentioned 60 million page views. How has that trended throughout the months? Have you seen an initial spike and then a tapering off? Have you seen a gradual build? What's it look like?

Nand Gangwani

That's a good question, Kit. I'm pleased to say that our page views for unique visitor actually has been going up since we launched the service. It did go up very dramatically when we launched the service, but even after the launch it's been going up pretty much every month. So we're really pleased with that metric because that shows that people are finding value and our site is really sticky, and we'll be able to monetize that much better going forward.

Kit Spring - Stifel Nicolaus

Are you seeing any increased sequential commitments from the advertisers that you mentioned? Will the advertising revenues be growing sequentially this quarter versus last?

Nand Gangwani

Definitely. Most definitely. The advertising revenues will grow sequentially every quarter going forward for the foreseeable future. I think we'll leave it at that.

We do think that we have a very strong pipeline. Right now, the issue has been getting the infrastructure in place in order to execute towards the pipeline that we have, but we feel pretty confident that going forward the sequential growth every quarter in the advertising revenues.

Chris Gorog

Just take the first part of your question there, Kit, yeah, we are definitely seeing repeat deals with advertising clients. For example, we launched with a couple of Disney movies, and they were very pleased with the results. They actually did an entire takeover of the site when they launched Pirates of the Caribbean, I think they're extremely pleased with that. So we're definitely seeing repeat interest as well as obviously continuing to grow our funnel of new advertisers.

Kit Spring - Stifel Nicolaus

Finally, I don't know if you'll answer this for me, but how would you compare the value of your company to Music Match, which I believe was acquired by Yahoo! in 1994 for around $160 million.

Chris Gorog

Well, that's an interesting question. I think if I recall correctly, I don't believe that deal went with any cash. So I think the first thing you do is add the almost $100 million in cash that we have which might get you to $260 million.

If you look at basically where Music Match sat at that point and where we sit today, I think we have a very significantly higher subscriber base. Again, I don't recall precisely where they were, but they certainly weren't remotely at over 500,000 premium paid subscribers. So that would be the first thing. I think our subscriber base is much larger than Music Match's was.

I think number two, obviously, the Napster brand itself is just infinitely more well-known than the Music Match brand. I don't believe they have any international footprint, whereas with the Japan launch we'll be in the top four territories in the world.

Lastly, I'd have to quickly say, they had no wireless platform. So in addition to leading all of our competitors in terms of the development of a wireless platform we are also now bringing back I think some very, very solid proof points with basically the top-tier carriers in the world. So I think it's actually quite interesting to look at that valuation and juxtapose it to where we are today and then certainly look at our share price, and I think that's notable.

Nand Gangwani

Just to add to that if I recall correctly, when they were bought, they'd just launched their premium subscription service. I think they had primarily the radio subscription at, I forget, $3 to $5 a month, so they didn't really have traction in terms of selling a $10 to $15 a month subscription service. So that's definitely a huge difference in terms of not only the back end infrastructure, but also the subsequent value of the subscriber base we have.

Kit Spring - Stifel Nicolaus

Thanks, guys.

Chris Gorog

Thanks, Kit.

Operator

Thank you. Our next question comes from Gene Munster - Piper Jaffray.

Gene Munster - Piper Jaffray

Good afternoon, Chris and Nand. The key take away here as you said if we can remember from the call it would be the mobile market, and just the explosive growth in device on that front. Which kinds of lead to the question of how are you going to get in front of all that? You've talked about DoCoMo, but can you maybe talk a little bit more about just from kind of a ground level, are you going to be marketing--essentially how are you going to get in front of all this explosive growth in new devices?

Chris Gorog

Thanks, Gene, for the question. I guess I'd quickly say I think we have evidence that we are doing it -- we're doing it. I think to nail the number one provider in Japan, we're very, very excited about it. We're very excited about our deployment with Suncom because it's a sophisticated deployment with over-the-air downloads and simultaneous dual delivery to the PC with a very, very large catalog, the largest out there.

I think in terms of how we will continue getting in front of wireless companies, I think interestingly, probably the most significant thing we can do is what we've already done, which is when you announce a relationship with DoCoMo, I mean it really is a tremendous proof point, and other wireless carriers around the world really look at that. Not only because they have market share leadership and such an important territory, but also in the case of DoCoMo, because they are really revered globally to possibly be the most innovative wireless company in the world.

So when they look at really all of the options out there and say we want to align ourselves with Napster, we think first of all, they make a decision around brand, which I think is always a mistake to not put right in the forefront, because it really matters, and it's really we get--is one of the significant reasons why we get these wins.

Secondarily, our platform is simply further developed than others out there. Our work with Ericsson has been very important. You will see over the next year we will really take our successes now in the US and Asia, and you will absolutely see some very impressive penetration in Europe. That has a lot to do with our alliance with Ericsson.

I think we are getting a very, very good head start here. I think it's brand, I think it's platform, I think it's our association with Ericsson. I think it's now kind of the proof in the pudding wins, all of which will stack up to keep this opportunity rolling.

The other thing I would mention, which I think you all probably understand but is probably worth mentioning, when we talk about the wireless opportunity we're not only talking about over-the-air downloads and ultimately over-the-air subscription, but we're also talking about putting together marketing programs so when someone signs up with one of these wireless carriers in-store, makes a decision about a cell phone, they ideally will be walking out of the store with a Windows Media Audio portable subscription enabled cell phone with an upsell to Napster.

It is providing an attach rate for our core PC-based subscription service as well as the new business of over-the-air downloads; and then ultimately over-the-air subscription. I hope that helps kind of rounding out the story.

Gene Munster - Piper Jaffray

The other relationship with DoCoMo, do you actually see a day where you would be purchasing a phone and inside it would come with Napster pre-loaded on it? I get the idea you got the 800-pound gorilla on your side here, but just from a grassroots perspective, how do you get people to actually say okay to Napster? Is it at the point of activation, is it marketing within the box? How would that work?

Chris Gorog

Okay. Let's look at Suncom for a minute. When are you in the Suncom retail store, there are actually point-of-purchase displays marketing the Napster product. Some of our to-be-launched products will include literally the Napster logo on the handset display, where it is the only default on the phone. So I can't talk in any detail further than I have about how the DoCoMo deployment will work or how subsequent deployments will work.

Yes, when you start thinking about bundled on the handset, yes, bundled in the box, yes. Pitched at retail, yes. So obviously that a great question because that's where the rubber meets the road. It obviously is a big difference between availability and being actively marketed, something that is also easy to understand and find. So we're working very carefully on the executional side of this because if executed well, it can make a huge difference to our business from an attach rate perspective.

That's where a great deal of our attention is going to. I would say that there is not only no pushback from the carriers that we're working with but that's precisely what they want to do.

Gene Munster - Piper Jaffray

Great. Thank you.

Chris Gorog

Thank you.

Operator

Our next question comes from Lee Westerfield - BMO Capital Markets.

Lee Westerfield - BMO Capital Markets

Thank you, gentlemen. Good afternoon. I have actually two questions. First, it's really a follow-up in greater detail on the subject you've just been talking about. Could you go into a little bit more detail about back end development software, interoperability with mobile devices? I'm specifically here hoping you're going to use your experience with Ericsson as the prototypical example. I think that would be the first question just so we understand the development of the mobile marketplace in greater detail.

The second question relates to the ongoing negotiations for new royalty structures for music subscription services and for download practices with the new Copyright Royalty Board. I wonder if you could update us about the status of those discussions at this stage?

Chris Gorog

Sure, Lee. Let's see, in terms of the mobile platform, I guess the first thing I would emphasize is as we've mentioned in the past, we see a tremendous amount of activity gravitating around Windows Media Audio in the mobile space. This is very different than it was 12 months ago. 12 months ago, some people might have even said WMA was, if not a dark horse, having to struggle to become the ubiquitous format.

I think that's the one thing we're seeing is I cannot think of an important carrier or major handset maker that is not planning to roll WMA out basically with all of their phones over the next year. So I think that's really from our perspective the most important point. We are very flexible because our technologies are compatible with OMA, are compatible with AAC. So we have a lot of flexibility and can certainly operate without WMA. But right now, that seems to be from our perspective on its way to becoming the ubiquitous platform.

In terms of the activity going around with potential legislation with music publishing, I don't have any great insight beyond what we're all reading in the papers. Our lawyers obviously are involved, inputting into that process. I think it probably goes without saying that we're very hopeful that there is a legislation passed that allows a basic industry-wide royalty rate because the moment it happens it will allow us to dramatically increase the size of our catalog.

If you guys have been paying attention to the whole theory around the long tail and the recently published book by the editor of Wired basically the hypothesis is the more content you have that there is a very direct correlation exponentially to growing your revenue.

So we've certainly seen that ourselves as we move from 500,000 tracks to 2 million. The prospect of moving from 2 million to 4 million is very exciting. I think it will really impact actually the health of our business and of course it will just make it a heck of a lot easier, as well. So we're certainly excited about that happening. I think that most people believe that it will happen.

Lee Westerfield - BMO Capital Markets

Gentlemen, thank you very much.

Chris Gorog

Thanks, Lee.

Operator

Our next question will come from George Sutton - Craig-Hallum.

George Sutton - Craig Hallum

Hi, guys. Personally, I do appreciate the M&A discussion you had. With respect to the Suncom relationship, I assume as you go through that process with them, you begin to talk about penetration rates and what sort of opportunities there might be. Can you just give us a sense of how high or how low are the expectations from that perspective?

Chris Gorog

Well, I think, George, I'll let Nand jump in here. I don't imagine he's going to rush to provide a lot of detail around just the Suncom estimates.

Nand Gangwani

George, I think we'll give more guidance on our wireless initiatives probably next quarter, once we announce some of the major deals. But I think you're looking at significant impact to our subscriber and revenue numbers sometime next year. This year we'll definitely benefit from all of these deals tremendously. But in terms of a meaningful financial impact, it would probably be middle to end of next year. But we'll definitely give you more visibility once we announce some of the other deals, well into the next quarter.

George Sutton - Craig Hallum

Just so I'm clear with respect to the wireless opportunity in the very short term, are you first offering just over-the-air downloads versus the subscription?

Nand Gangwani

That's correct.

Chris Gorog

With Suncom.

George Sutton - Craig Hallum

With Suncom specifically?

Chris Gorog

Right. But again, you'll see not only over over-the-air deals but also subscription-marketed relationships before the end of this year.

George Sutton - Craig Hallum

Chris, you made an interesting statement. You said a lack of a powerful device ecosystem is really what has held you back, and I completely agree. You say that is now becoming unblocked. I want to make sure I understand what you mean by that. Obviously cell phones being one answer. But obviously MP3 players that are Napster compatible being another. Can you put a little more specificity on what you meant there?

Chris Gorog

George, I was primarily focused on the music-enabled cell phones because when we build this business, we have to always be concentrating on the big picture, and that is the big picture. It's just difficult to imagine how a stand-alone MP3 player will really survive with ubiquity when you can get all that great functionality on your cell phone handset. I think we're all going to be migrating toward that.

The stand-alone MP3 player, over the next I guess three to five years I would say, will become just less and less important.

However, the near term always is important. What I'm also equally excited to say at least with respect to the near term is that there are some really good devices out there right now. I think I might have mentioned in our last conference call about our excitement around the new Samsung product, the Samsung Z-5 in particular is what I'm using which is a really outstanding 4 gig device, beautiful cosmetics and most importantly, it works perfectly with Napster To Go.

I mentioned our Power Sync technology, which we rolled out in Q1 which basically attacks a lot of the things that were wrong with the portable subscription technology. We have just much more rapid sync now, much greater or much less air waves. We actually decreased our calls into customer service by 50% after we rolled out the Power Sync technology. Those that had issues with syncing a portable subscription, we decreased the time on the call by 50%. So this is not an incidental issue.

The new technology Power Sync, I think, is going to be another way we really separate ourselves from our competitors, at least particularly in portable subscription. Then again looking to this device ecosystem, it's just really great to be able to say it's finally here. With each passing month, we will just see more and more MP3 players and many, many more music-enabled cell phones. That's the ecosystem that basically I think is coming to the rescue.

George Sutton - Craig Hallum

As you begin to look at the changes you might make to the free Napster strategy in terms of trying to bring subscribers in earlier in the process, would that potentially involve changing the number of free songs you get, are you thinking of doing more at the front end in introducing them to the pay product?

Chris Gorog

Well, George, I think probably the important thing to understand is everything's on the table. I think that we're certainly not the only ones out there in the entertainment and technology world that is very keenly focused on trying to find the exact proper balance between free content offerings and paid content offerings. What you're seeing in our transition here last quarter is just that.

The thing that gives me a lot of confidence is we have many tools in the toolbox in terms of improving conversion. As you've mentioned, the front end experience, it's a fairly significant change to go to a free service, or what we've done now for first-time visitors is go to a landing page that pitches you the subscription product but also gives you the opportunity to visit free. So that's very significant.

But there are ten other, I think, quite significant things that we are working on and implementing, all of which will unquestionably improve conversion. I think it's just finding the right balance. I think that our strategy, I believe we have as I mentioned in our script, I think is proving itself out in the sense that if you look at all of the key metrics that we were seeking: increasing visitation, being able to be in a position to decrease our ad spend, the conversion metric now has to be attacked, and we'll do it.

George Sutton - Craig Hallum

Last thing if I could. Could you give us an update on the XM relationship now that we've seen some of the players released?

Chris Gorog

XM as I think I've mentioned in the past is a five-year deal. I think the most important thrust of our relationship with XM is to merge these two product offerings. I think that this is really the initial stages of the relationship. The new devices are great. They've been reviewed very well. But they're high end devices. They're really just beginning to be marketed.

So our roadmap, which I can't reveal any further detail about, but there's some significant things we're going to be doing with XM over the next six to 12 months that I think will really enhance the reason why an XM subscriber will be excited about also becoming a Napster subscriber and having the fully integrated experience. So I think the way to look at it is we're really just getting going. But I do think it has a lot of promise over the long term.

George Sutton - Craig Hallum

Great. Thanks, guys.

Chris Gorog

Thank, George.

Operator

Our next question will come from Barbara Coffey - Kaufman Brothers.

Barbara Coffey - Kaufman Brothers

Yes, good afternoon. Again, a couple quick questions. First, when you look at these arrangements with the carriers and the cell phones, do you anticipate that people will have two separate bills -- one to Napster.com, and one through their cell phone carrier -- or do you expect that you'll be able to be bundled with that kind of service?

The second question is, we've gone through sort of generation one, now we're on generation two of the MP3 players that work with Napster. Do you anticipate having to go through a couple versions of cell phones to get seamless usage?

Chris Gorog

Okay, great question. Integrated billing on the wireless platform ultimately I think is going to be very important for adoption and retention. So we're working on integrated billing with all of our partners. So very good question, and the answer is you will definitely see that.

With respect to working out the kinks of the music-enabled cell phones and making sure that they work great right out of the box as opposed to going through some of the growing pains we did with the MP3 players, I would say a couple of quick things about that.

One is we're working very closely with the handset manufacturers. The wonderful thing about creating a relationship with someone like DoCoMo--and I'll just use them as an example--is instantly we have the handset manufacturers calling us and saying, how do we become compatible with Napster To Go, as opposed to our having to call them. So that's very important. Then we work very closely with them to make sure that their interoperability is great.

So I think we'll be much more successful even on the earlier handsets in terms of providing a great experience for consumers.

Operator

Thank you. Our next question comes from PJ McNealy - American Technologies Research.

PJ McNealy - American Technologies Research

Good afternoon. Two questions for you today. One is on the $1.9 million for the one-time revenue, is it reasonable to assume that this is a leftover from Best Buy and that the auditors finally agreed to recognize it at this point?

Nand Gangwani

It is related to prepaid cards, the revenues that were sitting on our balance sheet because folks hadn't redeemed it. No, we recognize revenues only when consumers redeem the tracks on the prepaid cards.

This does not have anything to do with the Best Buy relationship except that, obviously, Best Buy did contribute to a good portion of the prepaid card revenues. The reason we recognized it this quarter was because we had certainly legal formalities to complete, which we completed this quarter. As a result of which we can now recognize and record as revenue.

PJ McNealy - American Technologies Research

Another question. If we look at the paid subs quarter-over-quarter, I mean, they are now trending obviously from 547,000 down to 508,000 quarter-over-quarter and that's without the college kids. Is this a source of concern?

Chris Gorog

PJ, I don't know how to address that other than how I already have. Of course it is. We fully anticipate that we would have impact to our subscriber growth. I think that we launched Napster.com really deeply focused on creating a great experience with the free product. To the detriment of the subscription upsell. If you jumped on Napster.com when we launched, we were very subtle about the subscription upsell.

It was purposeful because we really wanted to get consumers very excited about the free product. It just really goes back to what I said. It's very important that we find the right balance. I think we learned in our first quarter that we didn't have the balance right and that's why we are very aggressively attacking just restoring conversion to healthy levels. Again, I am just repeating myself, but I think that we have a very high degree of confidence that we will.

Our statement that we'll be back in positive territory with subs and growth during this fiscal year is I think evidence of the fact that of course we are very attentive to that dynamic.

Nand Gangwani

Right. And just again after that, PJ, as Chris pointed out, obviously we've actually made strong traction on pretty much every other metric. Our unique visitors have gone up substantially. Our page views have gone up substantially and are continuing to grow. Our costs per UV have been coming down sequentially. And our churn also has been coming down, and it's pretty much at record lows right now. It's at the lowest point it's been since we launched Napster.

So we have made really good traction on a bunch of the key metrics. The conversion ratios we're going to continue to work on, and we'll definitely have that figured out before the December quarter rolls around.

PJ McNealy - American Technologies Research

Thank you.

Operator

Our next question comes from Ingrid Ebeling - JMP Securities. Please go ahead.

Ingrid Ebeling - JMP Securities

Hi, yes, thank you. Do you anticipate having to ramp-up sales and marketing expenses over the next couple quarters then to get those sub numbers back up until the ad revenues kicks in and the conversion rates pick up some?

Nand Gangwani

As I mentioned, Ingrid, we will be actually controlling our marketing spend, so our marketing spend will be going down this current quarter. I'm not guiding beyond that in the December quarter.

We traditionally spend a little bit more because we get the best bang for the buck from an NOI perspective. But overall, our goal remains to manage the marketing and sales expenditures downwards over the longer term because we think this is a much more effective way to get the traffic. We're going to try to bring the cost per UV down sequentially.

Operator

Thank you. And our final question will come from Darren Aftahi - ThinkEquity Partners. Please go ahead.

Darren Aftahi - ThinkEquity Partners

Hi, guys. Just a handful of things. First, on the wireless carrier front, you mentioned there's potentially a top-tier announcement coming in the fall. Without going into too much detail, can you address why it is that DoCoMo and this other larger carrier is choosing your platform?

My second question would be in thinking about how you guys drive more traffic to Napster.com, something we haven't really heard a lot about, but I know it's probably part of the strategy. How are you addressing targeting the whole peer-to-peer crowd, because that seems to really be driving consumption of content in both audio and video on the web?

Chris Gorog

Okay, thank you, Darren. In terms of why we're meeting with the success that we are from the wireless industry, I would say that again it is a handful of things. I think brand gets us in the door. I think they're looking for a way to differentiate themselves from others. Clearly every wireless company in the world is going to be offering some type of music offering. To be able to say they're offering Napster as a way to cut through the clutter, so I think that's always very important.

I think number two, our ability now to offer over-the-air downloads, but also dual delivery to the PC through the Napster subscription service is very critical. And again, a big, competitive differentiator between simply an over-the-air service.

I don't think anybody gets excited about creating a music collection that would live forever on their cell phone, and so that's a very important element from a consumer perspective and therefore, to wireless companies, as well.

I think they're very excited about the concept of being able to deliver over-the-air subscription with integrated billing, and seeing that recurring revenue. Again, there are not many companies that can talk seriously about doing that, and we're talking seriously about deploying it in 2007.

I think just the experience we have now with the platform, the relationship with Ericsson,. I really think you put all those things together, and we rise very quickly to the top.

Going to your second question about Napster.com, Darren, I'm not sure I heard it correctly. I think you were asking what our expectations would be for our visitation growth, was what it?

Darren Aftahi - ThinkEquity Partners

More in regard to there's this huge audience of peer-to-peer out there that really is driving a lot of sort of growth in handheld device purchases. How are you guys going about targeting that market in particular? Doing anything that could potentially drive traffic to Napster.com or something of the like?

Chris Gorog

That's great. Well, of course you're right. There's extraordinary amount of interesting peer-to-peer activity going on out there. We are experimenting, figuring out how to address that audience. In fact, if you saw our visitation over the last quarter, you would have seen an astronomical spike when we started experimenting a bit with some of the peer-to-peer network. So it's very interesting, I think does provide some very solid opportunities for us.

We have to be cautious about it because again what we have to be focused on conversion, and it's really getting that balance. So does a free peer-to-peer user ultimately qualified as a potential subscriber? That's certainly a debatable subject. But suffice it to say we're all over experimenting around and trying to find the answer to that question.

In the meantime, we do have some very interesting viral activity going on with Napster links. The Napster links, were immediately adopted by a lot of the most interesting sites out there. You can find Napster links on MySpace and Blogger and Yahoo! and Facebook and many, many other websites and blogs.

I think that aspect of really creating a viral effect in terms of driving top line visitation is also a very deep focus of ours. I think you'll see a lot of improvements over the next three to six months as we get better at creating tools for the community so they can interact with Napster in ways that they want to, and again, really bring their web products and their blogs and emails to life and so forth with Napster products.

So you'll see a lot of new development coming from us in that regard.

Darren Aftahi - ThinkEquity Partners

Thanks.

Chris Gorog

Thank you, Darren.

Operator

Thank you. Management, at this time I'd like to turn the conference over to you for any further remarks.

Chris Gorog

Thank you very much for joining us today. We'll see you next quarter.

Nand Gangwani

Thank you.

Operator

Thank you, management. Ladies and gentlemen, at this time we will conclude today's teleconference presentation. We thank you for your participation on the program. You may now disconnect, and please have a pleasant day.

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Source: Napster Q1 2007 Earnings Conference Call Transcript (NAPS)
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