Up until this week, almost no one had heard of the small media firm Atrinsic (ATRN). The company's stock began trading under the ATRN symbol in 2009 and had been a consistent loser up until recently. By September 2010, the stock was languishing under $2 a share (reverse-split adjusted) and the company appeared to be meekly drifting off toward bankruptcy. Suddenly, an electrifying pitch hit the marketplace: Atrinsic's Kazaa music subscription service would revive Atrinsic's fortunes. Shares soared with the stock gapping up more than 80% Monday and shares have stayed at an elevated level in volatile trading all week. On Thursday, Atrinsic briefly surged more than 50% in the morning after the shares had sunk to under $4.50 on Wednesday.
Briefly the bullish pitch goes as follows (John Gilliam's compelling though flawed bullish thesis for Atrinsic can be found here and here): Atrinsic's Kazaa is going to be a leading subscription music service in the future because it can get around Apple's (NASDAQ:AAPL) rules regarding royalty payments, Kazaa generates the most subscription revenue per user in its space, Pandora will soon go public at a high valuation and Kazaa will bask in the resulting limelight, also that Kazaa is an iconic brand that garners user attention, and finally that Atrinisic also has another business line that by itself justifies much of the company's market cap.
Let's break down the arguments. I am happy to concede the first -- Kazaa's way of dodging Apple's rules is a nice innovation. However, there is precisely nothing to stop competitors from doing this as well. The second argument that Kazaa generates more revenue per user is also true, though it is irrelevant. Kazaa's user base is far smaller than the other paid subscription services, let alone the mostly free Pandora or Last.fm [a property of CBS (NYSE:CBS)]. Among paid services, Alexa shows that Real Networks' (NASDAQ:RNWK) Real.com comes in at #1,747 in worldwide internet traffic, Rhapsody at #5,649, and Napster.com [now a property of Best Buy (NYSE:BBY)] at #10,182. All are far more popular than Kazaa, which clocks in at only #22,170, and whose web traffic has not been rising over the past couple years.
Probably more importantly, Kazaa's revenues are a pittance compared with bigger players. Both Pandora (a mostly free service) and Napster (a direct paid rival) are generating more than $100 million in annual revenues. Through the first three quarters of 2010, Atrinsic, by comparison, had generated only $15 million in subscription revenue. And in the first three quarters of 2010, subscription revenues were up only 1% versus the comparable period in 2009. In addition, we find this in the Atrinsic 10-Q:
For the nine months ending September 30, 2010, the Company has presented in its statement of operations, Kazaa revenue of $8.4 million and expenses incurred for the Kazaa music service of $12.1 million, offset by $0.6 million of reimbursements from Brilliant Digital.
Not only is Kazaa's revenue much lower than competitors and stagnant, it is also unprofitable revenue. The company is running somewhere in the neighborhood of a -30% margin on Kazaa as of Atrinsic's latest filing. Kazaa's performance better start improving rapidly, or Atrinsic shareholders are going to end up disappointed.
Moving on to the next argument, any hint of comparison between Pandora and Kazaa is misleading. Pandora is a top 300 worldwide internet property with tons of users outside the United States, its web traffic continues to grow, and it also allows users to get long samples of the free product before having to pay to improve the experience. A much better comparison for Kazaa is with Napster, whose past history and business model share more similarities.
Napster is also an iconic brand, like Kazaa, that originally was on the illegal side of the music business and later turned clean. It also was high-profile (arguably higher profile as founder Sean Parker has had lasting cultural significance as his recent role in the movie "The Social Network" shows). Napster stock traded as high as 25 in 2002, and would remain above five dollars for quite a few years, but eventually slumped under $2 as the failure of its business model eventually became apparent. Best Buy finally bought out the struggling company at a price far below what Napster investors had hoped to receive. While Napster was able to use its iconic brand to make some sort of a business for itself, it certainly was not a dynamic or exciting one that generated any meaningful shareholder value.
While Kazaa could become a powerful player in the subscription music business, the odds aren't favorable. The business is competitive and margins are low (negative in Kazaa's case). Kazaa's revenues are stagnant. If Atrinsic investors are buying into the company to get a piece of Kazaa, they are overpaying.
There is, of course, another aspect to Atrinsic's business. Atrinsic does offer what its website describes as "Full-service, performance-based online marketing solutions" and the company proudly basks in honor of having been "Named a Top 25 U.S. Search Marketing Agency by the Advertising Age 2009 Agency Report." However, this business has been in decline for years. As late as 2008, this business was a $100 million a year in revenue operation. But 2009 saw that figure get cut in half, and through the first three quarters of 2010, the "Transactional and Marketing Services" line of the company's revenue statement fell almost 60% more to only $17 million.
While Atrinsic does have two parts to its business, the Marketing Services division is in freefall with revenue precariously slumping. Clearly Kazaa is the future here, if Atrinsic is to perform well. However, as stated above, Kazaa itself doesn't look like a worldbeater. Is there anything on the balance sheet that could help? Unfortunately, no. The $4 million cash balance will last less than half a year at the company's current burn rate. With Kazaa's turnaround not here yet (if it ever gets here), the company will clearly either have to take on debt or do an equity offering.
One more note of interest. Going back in the way-back machine to 2008, we find that Atrinsic was previously the target of a glowing article on Seeking Alpha. Back then Atrinsic still traded under the name New Motion (formerly NWMO) and the stock was at $20 a share (pre-1:4 reverse split.) The same John Gilliam that wrote the two favorable articles about Atrinsic this week was the author of an ill-fated buy recommendation from 2008 in which he suggested that New Motion/Atrinsic's estimates of $160 million a year of revenue were conservative and that growth would continue at 40% a year.
Now that division of Atrinsic is barely providing $20 million a year in revenue and the company's stock has dropped more than 75% since the buy recommendation. While analysts all make mistakes, Gilliam's past misfire raises doubts about his aggressively optimistic predictions for Kazaa and Atrinsic today. I also wonder about the quality of Atrinsic's management given those failures and the fact that the Andrew Stollman, Atrinsic's president, left the company just last month. When I look at Atrinsic, I see a company with two money-losing business segments that is almost out cash and appears to be in the clutches of a death spiral. I don't see any way fair value for Atrinsic could exceed $2/share.