Last week I wrote an article that pointed out what appeared to be a growing and substantial short interest in Atrinsic (Nasdaq: ATRN), the owner of Kazaa. Within 24 hours of the publication of that article, an article was published about ATRN by one of the most prolific “short story” authors of 2011. Mr. Ian Bezek has published 22 articles that make very persuasive arguments for why a given stock should be sold short since he graduated from college in December.
For those who are counting, that is more than one short recommendation for every 3 trading days so far this year. If you take a look at the companies he has written these “short stories” about, you will find that many of them had precipitous declines in their share price leading up to (and sometimes following) his article. Nearly all had substantial increases (sometimes in the millions) in the number of shares that were sold short in the reporting period following his article.
Is this article an indication that ATRN has become a favorite target of short sellers? We may not know for a few weeks given that the next settlement date for the reporting of short interest (Tuesday) will not be reported until next Thursday. But the fact that ATRN’s entire public float turned 6x in a five day trading period, combined with the article by Mr. Bezek, suggests that ATRN is a new favorite target of short sellers.
Mr. Bezek is obviously an extraordinary writer in terms of style, content and volume. I believe he was correct about some of the points he made and even though his conclusions missed the mark, they were presented in a very compelling way. I believe that he is making the same mistake I have made in the past - taking a cursory glance at a company’s reported numbers and jumping to the conclusion that the company will continue to perform in that manner, regardless what is happening in the broader marketplace that should tell us that something is changing. Below, I go through each of the seven points of the short story to show the errors he made that could lead an investor to the wrong conclusion about this company and where it is headed:
1) The article suggests there is no reason to think ATRN’s position among other industry players relative to Apple’s (NASDAQ:AAPL) new 30% levy is a big deal. He is 100% correct when he says “there is precisely nothing to stop competitors from doing this as well.” However, that completely misses the point, which is that Kazaa’s competitors have been weakened substantially by Apple’s new rules regardless of whether they follow Kazaa‘s lead on how to deal with it. A key understanding here is that most streaming music companies’ growth assumptions before the App Store fee announcement were substantially different than they are today because they have no idea whether they will be able to continue to use the App Store to profitably acquire customers, which for most of the streaming music services is their #1 source of new subscribers.
The other important aspect is that none of Kazaa’s customers expect to use an App to access the service, while each of their competitors may have increased attrition if they surprise their customers by removing their Apps from Apple’s App Store - not part of the original bargain. Kazaa’s announcement of its mobile service last week was also not part of its original bargain with subscribers - it gave them something of substantial value for free.
2) The article concedes Kazaa’s industry leading ARPU (average revenue per user), but says it is irrelevant - this is a big red flag here on the depth of the industry's due diligence. ARPU is one of two key determinants (the other is LTV - Life Time Value) of the value of a company’s subscriber base in an industry where the most relevant factors in determining the success of your business model are:
1) how many subscribers you can get
2) what price you can get them to pay and stay
3) how long you can keep them
To suggest that Kazaa’s ARPU is irrelevant because they are currently smaller than some of the other players in the space suggests a fundamental lack of understanding of what constitutes value creation in this space.
3) “Kazaa’s user base is far smaller than the other paid subscription services.”
I do not believe that this is accurate. While we know that Kazaa’s subscriber base is smaller than Rhapsody, Napster and Spotify, there is strong anecdotal evidence suggesting that Kazaa’s user base and/or subscription revenue is larger than Rdio and MOG. Regardless, to suggest that Kazaa’s user base is so small that standard industry metrics would become irrelevant is simply wrongheaded.
4) The author attempts to convince us of Kazaa’s smallness and irrelevance by comparing its website traffic with that of Real.com. The entire approach used in this argument suggests a very cursory due diligence process, as the author apparently did not realize that Real.com is no longer in the streaming music business. Real exited streaming music a little over a year ago with the spin off of its minority stake in Rhapsody, so Alexa traffic rankings of Real.com vs. Kazaa are not particularly relevant.
I found it equally as interesting that he used worldwide traffic rankings for the comparison instead of US rankings. Either he did not know that Rhapsody, Napster and Kazaa all operate only in the US or he was trying to make the difference in the numbers seem more dramatic. Rhapsody and Napster are the two largest music subscription services in the US, so they are ranked higher, with Rhapsody at #1481, Napster at #3752 and Kazaa at #6591. He did get one aspect of this argument correct - Kazaa’s web traffic had not been rising during 2010 as they did not market the service aggressively while they were still building out the streaming, social media and mobile functionality. Of course, all of those major upgrades are now complete as of last month so we will likely start to see a more aggressive marketing campaign in Q2.
5) “Kazaa’s revenue is a pittance compared to bigger players.”
While it is true that Kazaa’s total revenue is smaller than Pandora’s, Kazaa’s subscription revenue is actually 25% higher than Pandora’s. Napster’s subscription revenue is substantially higher than Kazaa’s, as would be expected given the large retail distribution network they enjoy through their parent company (Best Buy (NYSE:BBY)).
6) “Not only is Kazaa's revenue much lower than competitors and stagnant, it is also unprofitable revenue.” The author appears to be unaware of the fact that there is not currently a profitable player in the streaming music space. He also states that Kazaa’s revenue is much lower than competitors when that is only partially true (some have more, some have less). It appears he also did not realize that Kazaa was transitioning from a download only service to a streaming and download service during calendar year 2010, which is why the company wisely chose not to spend too heavily on marketing while they completed the build out of the service.
Had the author dug a little deeper dig into the SEC filings, he would have known that Kazaa’s subscriber base is growing rapidly and that management is expecting sequential growth of 10% in subscribers, which is hardly stagnant, and if achieved, will place them among the best percentage growers in the space. To say that they were stagnant through last September would be true. To say that they are currently stagnant is directly at odds with information available in the marketplace (the subscriber base has grown from 64,000 to 75,000) and growth projections released by the company in SEC filings.
7) “A much better comparison for Kazaa is with Napster, whose past history and business model shares more similarities.” We agree on this. Investors should consider that Napster was sold to Best Buy in a “fire sale” price of $121 million after its stock fell over 85%. The deal valued Napster at somewhere between 5x and 20x Kazaa’s current implied value (depending on how you value Atrinsic Interactive). Napster’s business was contracting, it was burning through about $11 million in cash per quarter (though they still had $60m+ in cash), and the company’s board was apparently very motivated to sell it.
As I mentioned earlier in the article, I have made the same mistake in the past that Mr. Bezek seems to have made in reaching his conclusion that ATRN is worth something less than $2 per share. His article cleverly points out a very good example of my error in doing that, where I wrote that I expected Atrinsic's growth rate to accelerate in 2008 following its merger with Traffix. My cursory due diligence led me to overlook the context around the growing revenue numbers. It also led me to ignore what in hindsight appears to be quite obvious indications that an upheaval had already begun in the lead generation space where the FTC essentially put a halt to many practices that were widely employed at that time. Such activities were a major component of Traffix’s revenue and I should have looked much more closely at the FTC enforcement actions against Valueclick and other players in the space before suggesting that they could continue to grow that revenue stream.
Thorough due diligence requires that we understand the risks that came with the rewards of that revenue stream. Looking to see what was going on in the broader lead generation space would have led to a different conclusion and a better result. Similarly, if Mr. Bezek were to dig a little deeper into SEC filings and survey the broader streaming music landscape, he would have discovered information available to all that would have helped him to understand why most of the points he made about Kazaa may have been true six months ago, but are hardly indicative of where Kazaa is today or where it is headed.
Given that ATRN is apparently in play with short sellers now and given my own appreciation for the value they create in terms of liquidity (for current ATRN shareholders) and exposure (Kazaa in the news due to their frenzied share buying), I thought I should share my top 5 questions for short sellers in deciding whether they want to put capital behind the sub $2 ATRN valuation thesis:
1) Are you aware that ATRN has a publicly available float of only 1.4 million shares or less? After the first article on ATRN was published, I was contacted by several large holders who viewed ATRN as a “long term holding“, but their stake was below the 5% filing threshold. This would make the number of shares available for public trading much lower than 1.4 million, possibly even below 1 million.
2) What if ATRN announces it has sold or will spin off its marketing services division (Atrinsic Interactive)? The historical valuation for the sale of such assets has been around 1x revenue, though the last acquisitions of the top 10 players were Hearst’s purchase of iCrossing at 3x revenues and Dentsu’s acquisition of Innovation Interactive, which reportedly was at a premium higher than 3x revenues. Atrinsic Interactive’s trailing twelve month revenue run rate is a little over $22 million right now, so you might want to do the math on that one.
3) What if ATRN hires a high profile CEO to run Kazaa? The recent departure of the president of ATRN opened up close to $500k that could be used (with stock options) to bring in a heavy hitter.
4) What if all the attention lavished on the company over the past week results in an awakening of consumer awareness of the iconic Kazaa and its return to the marketplace, resulting in increased subscriptions/traffic/revenue? Note that the same Alexa data source used by Mr. Bezek also indicates that Kazaa has experienced a traffic reach increase of 16% over the 7 days following the Apple / mobile streaming announcement.
5) What if a significant percentage of the short sellers sense that they are about to get squeezed and decide to “box” their position, choosing to quit the fight and run away so they can fight another day (at a higher price)? In the K-tel situation I mentioned last week, the short sellers were actually the ones who ended up being right. Those who were smart enough to hold on to those short positions that are so hard to get by “boxing” them with a corresponding long position must have made a fortune riding it back down from $106. If a significant number of the current short position holders were to decide to do that, it would exacerbate the move higher and cause greater losses for those who do not.
The tiny float combined with the increasingly aggressive short selling has ATRN wound up tight like a coiled spring. Any catalyst could trigger the spring, but I believe it is now wound so tight that it may not even need a specific catalyst. Any uptick in buying could trigger a run on the shares and I would not be surprised to see some shorts who established a position last week decide to cover, or at least box their position, now that they know the rest of the story that last week’s “short story” failed to mention.
Given the sell off that has occurred since the flawed analysis was published (the stock is down to $3.40 - a sell off of over 35% since Thursday’s close) and the tendency of these momentum shifts to snowball, I would not be surprised to see ATRN recover all of that decline and then some rather quickly. Additionally, the occurrence of any of the catalysts mentioned above could easily push ATRN to a new 52 week high.
Disclosure: I am long ATRN, GOOG