Apple's New Subscription Rules May Clear a Path for a Kazaa Comeback

 |  Includes: AAPL, ATRN, BBY, GOOG
by: John Gilliam

Much has been said, blogged, tweeted and expletive deleted since Apple's new App Store subscription rules were announced two weeks ago. The backlash has been enormous; the general theme seems to be that the streaming music subscription services have been kneecapped and that either Apple will have to make some kind of exception for streaming music companies, the music labels will have to absorb some of Apple's 30% revenue share, or the services will have to raise their prices across the board to make up the lost margin IF they choose to continue to participate in Apple's App Store.

Most commentators on the issue have done a good job of breaking down the carnage among the key players in the streaming music space, but there has been little if any mention of the one company that should actually BENEFIT from Apple's new rules. Kazaa (owned by Atrinsic - Nasdaq: OTCPK:ATRN) is an on-demand streaming music service that could see its fortunes impacted positively by Apple's new rules, something that has seemingly been overlooked by most commentary on the subject. It is entirely possible that it has been overlooked because the new Kazaa is essentially still in Beta, though it has already amassed around 75,000 subscribers. Alternatively, it is possible that many have overlooked Kazaa because they still think of it in its original conception as a P2P file sharing service that allowed consumers to download free music.

Kazaa in its first iteration was downloaded over 800 million times and at its peak was being accessed by more than 50 million users per day. Obviously, the new Kazaa streaming subscription-based model makes it a completely different animal that more closely resembles its competitors Rhapsody, Napster, Rdio and MOG, but we think Kazaa still has significant name recognition due to the previous number of downloads, and this, combined with its unique approach to marketing streaming music subscriptions, will allow it to not only survive, but thrive in this space regardless of whether or noot Apple backs off its 30% levy on App Store subscription plans.

We believe that the music labels want desperately for companies/models to emerge that are profitable and able to challenge the iTunes approach to the distribution of their product. What's needed is a company that can make enough money to not only survive, but continue to invest in innovative marketing/delivery/content concepts that bring more consumers of music into the fold and cause existing music fans to consume more and value it more highly. Kazaa has the potential to be such a company, and its ability to grow outside of the App Store ecosystem while successfully marketing its premium ($19.99) multi device service option makes it one to watch in this space.

The streaming music space as currently constituted is a market that is actually quite small and fragmented. There are two companies that have achieved some significant measure of scale (Rhapsody and Napster's last publicly available figures put them in the 700k - 800k range) based on the publicly available subscriber counts, and a third (Spotify) that has achieved that range in Europe. The differences between the available music libraries of the players in the space is so small as to be irrelevant to the average consumer (focus on the words "average consumer," all you indie label fans who are about to flame me for writing that) and the pricing plans have all gravitated towards the same basic structure. All have created user interfaces that allow a consumer to search the millions of listening options by song, artist, album, genre, etc. Thus, the base product and pricing framework is largely the same with all of the current players.

The innovators in this space have the been the smaller, more entrepreneurial upstarts Kazaa, MOG and Rdio, all of whom add value for consumers (and thus the music labels) by offering significant social media integration and music discovery tools. Each of these has built a better mousetrap with regards to features that allow users to see what their friends are listening to (in real time), see what other people with similar music preferences are listening to, and generally provide tools that allow users to experience the joy of musical serendipity. We believe these features (social media integration and significant music discovery tools) to be among the most important pieces of the puzzle necessary for the music labels to see the perceived value of their product appreciate and for paid consumption of their product to increase.

Apple's move last week puts a spotlight on the most vital characteristic that will determine which of the current players survives, which ones are gobbled up in the inevitable round of scale building consolidation, and which ones end up like the many music services that died along the way: How does each build its subscriber base? Rhapsody, due to its ownership structure (Joint Venture of Real Networks & MTV), has acquired a significant part of its user base through marketing channels associated with its majority owners, which means that it will be not just go away if it is unable to market through Apple's App Store. However, the App Store appears to have been the most significant source of its recent growth, and any scenario that removes Apple's store as a source of new subscribers will likely result in their base stagnating at best and possibly even declining. We believe that this along with Rhapsody's scale and ownership structure make them among the ripest of the acquisition targets for the larger players that we expect to see entering the space of the next year or so, including Apple, Google (NASD: GOOG) and HP (NYSE: HPQ). Similarly, Napster has the advantage of being part of a larger corporate entity (Best Buy - NYSE: BBY), whose far-flung retail empire gives it a readily accessible channel for customer acquisition and whose considerable financial resources make it highly probable that Napster will survive. These two players have the advantage of big company resources behind them, they are long standing survivors in the music space, and they have larger subscriber numbers as a result of it. However, they also have the big company mentality, lacking the innovation that we see coming from the three smaller start-ups. This is why we see what is arguably a stronger subscriber value proposition emerging from the entrepreneurial environments at Kazaa, MoG and Rdio.

We believe that Kazaa will be the winner from among the three more entrepreneurial players due to its unique marketing capabilities and considerable expertise in addressing a significant market niche: its alternative billing option that allows its subscribers to sign up using their mobile phone number (no credit card required) and have their subscription charges placed on their phone bills. Kazaa's parent company (Atrinsic) owns a search marketing agency that was ranked among the top 10 digital search agencies in the US (2010 rankings by Ad Age) in addition to a highly regarded affiliate marketing network whose clients include Ctrip (Nasdaq: CTRP), Kayak and GEICO.

We believe the credit-challenged segment of this market has the potential to grow even faster than the colossal growth we expect to see in the streaming music market overall, due to the current economic difficulties that have left many consumers unable or unwilling to use a credit card. Somewhat like the explosive growth experienced by prepaid cellular companies such as Leap Wireless (NASD: LEAP) and Virgin Mobile when the recession started to wreak the most havoc on US consumers -- when prepaid/"Pay as You Go" type cell phones for consumers lacking credit actually surpassed the number of traditional wireless phone contracts -- we see Kazaa using its search marketing prowess and the considerable reach of its affiliate marketing resources to effectively reach this significant market segment. Kazaa has recently been experiencing 10% month over month growth in subscribers, and more than 75% of its subscribers now bill their subscription to a phone bill versus using a credit card. Additionally, due to the fact that an increasingly large number of teenage consumers too young to have a credit card now have smart phones, and to our belief that this demographic will be among the most likely to see the value of unlimited downloads and streaming, we think the Kazaa alternative billing niche will allow the company to grow at an even greater rate than the market itself over the next few years.

The implications of Apple's new subscription rules (in particular the 30% fee) for the streaming music industry are significant. Rhapsody, MOG and Rdio have all grown their subscriber ranks substantially over the last year by offering their free Apps through the Apple App Store. Though we only have subscriber numbers for some of the companies, reportedly none of them have reached profitability yet, and we know that each one's subscriber acquisition plans have been heavily influenced by their recent success through the App Store. Not only does this change have the potential to significantly curtail their ability to acquire new subscribers through this channel, but Rhapsody, Mog, Rdio all may have to go back to their existing customers who signed up to pay $9.99 per month and inform them that they will have to pay a higher fee to keep accessing their service through an App unless Apple decides to grandfather existing customers. If one of these companies should decide to drop the App Store channel all together, those same customers will be informed that they must log in with a browser to get their music. While not necessarily a deal breaker, that is certainly more onerous. This will surely lead to greater attrition than would have been expected otherwise. Kazaa will not have to deal with the issue of existing customer expectations, as it has not yet used the App Store as an acquisition channel.

Whether the persistent rumors of an Apple entry into the streaming music space materialize or not, the bottom line is that Apple's new App Store subscription rules will hobble each of these companies to some degree (except Kazaa) and will cause those who survive to make major changes in what they do and likely have negative implications for their revenue expectations going forward.

Thus the greatest beneficiaries of Apple's new policies (other than Apple shareholders) could be those who own stock in Atrinsic, the parent company and 80% owner of Kazaa (to be 100% owned when the formality of a shareholder vote is completed in a few weeks). With the stock currently trading in the $2.50 range and with only 6 million shares outstanding, the company's cash adjusted market cap sits at approximately $10 million. The company has no analyst coverage nor anyone with a vested interest in promoting the company other than its employees, who essentially own about half of the company's stock already and continue to buy shares. When you consider that ATRN's digital marketing agency could be worth upwards of $10 million on its own, investors at today's prices are essentially getting Kazaa for next to nothing. Even the smaller start ups in this space have received VC funding of $30 - $50 million and none has achieved a business that is as sustainable as what Kazaa already has in place.

As such, we believe that ATRN/Kazaa's stock is one of the best examples of a valuation disconnect that we are aware of, and we expect the happenings in the streaming music space to bring this to light very soon. Until Pandora floats its IPO, ATRN's Kazaa will remain the closest thing to a publicly traded pure play on the streaming music business, though there are actually very few of those "publicly traded" shares to be had. If you take the 6.2 million shares outstanding and back out the number of shares owned by insiders (33% per most recent proxy), 5% owners (39% per most recent proxy) mutual funds (6% per Yahoo Finance), the remaining shares that equate to a free trading public float is only about 1.4 million shares. Investors who are able to get some of these shares in the current trading range should be richly rewarded as capital flows into the space and investors seek to get exposure before the Pandora IPO by buying into one of the most recognizable brands (Kazaa) in the streaming music space.

Disclosure: I am long OTCPK:ATRN, GOOG