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It would probably be entirely reasonable if all the financial news published on Monday focused solely on the banking world: the bankruptcy of Lehman Brothers (LEH), the sale of Merrill Lynch (MER), the ongoing saga of Fannie Mae (FNM) and Freddie Mac (FRE). Books will be written about these events. Analysts and academics will probe the “whys” and “wheres” of what happened and try to lay out a map of how to avoid repetition. Policy makers may even push legislation to prevent recurrence (as was the case with Sarbanes-Oxley following the scandals at Enron, Tyco, Adelphia, Worldcom and others). 

Compared to these big headlines, the rest of Monday’s business news was small to the point of seeming irrelevance; still, there was plenty going on of merit within other markets. As one analyst’s comments suggested, the collapse of Lehman Brothers doesn’t stop Microsoft (NASDAQ:MSFT) from selling software or consumers from shopping at Wal-mart (NYSE:WMT). Life, and business, will adjust and move forward.

One piece of interesting news in the media, entertainment and technology sector was an announcement by retail giant Best Buy (NYSE:BBY) that they were purchasing digital music service Napster (NAPS) (press release). Comparatively tiny, in scale and scope, the news could be more significant than it might otherwise appear.  

A Short History: Napster’s Wild Ride

Few brands have survived as many near-death experiences or had as wild and varied a life in as short a time as Napster. In its original incarnation, the service - reportedly named after its founder’s bad hair days - was the epitome of "disruptive technology." Born from a dorm room in 1999, more than a year before the iPod hit the marketplace, the Napster file sharing platform was largely responsible for opening the flood gates of digital music distribution. It took obscure, geeky IRC and Usenet file sharing tools and made them accessible for the mainstream. It pushed the MP3 format, a compression technology that could have gone the way of Betamax, toward the public consciousness.

In 2001, the elevator ride to popular success fell backward with a crash, the first of many struggles. Instead of buying the service, which insiders had hoped would be the outcome, the world’s major record companies and a handful of musicians (Metallica most notably) aggressively chased Napster to court, charging their service enabled copyright violation and even encouraged it. The courts agreed and issued an injunction that effectively shuttered the business. A partial settlement was then reached where Napster agreed to pay millions, millions it didn’t have.

To raise the money, a subscription Napster was envisioned. The company tested a prototype of the service designed to allow legal (copyright encrypted/DRM attached) sharing of music and files in 2002. Unfortunately for them, rights and licenses from content owners (the music studios who had so recently been the company’s nemeses) were, not surprisingly, hard to obtain. The labels weren’t anxious to come on board and play as friends. Subsequently, Napster, the legal re-incarnation, never launched and the settlement debt lingered.

German conglomerate and music label Bertelsmann AG (now half owner of Big 4 music label Sony BMG) saw promise where its peers saw villain. The company offered a buyout, reportedly for $85m. A condition was that the company be sheltered from creditors in Chapter 11 bankruptcy.

Bankruptcy Court rejected that plan and instead, with mounting debt, Napster was liquidated in a Chapter 7 auction.

Roxio, then a software company recently spun off from Adaptec (in 2001), won the prize, outbidding porn companies and others with a bid of about $5 to $5.5 million. For the fee, they took ownership of the brand and trademarks. The deal was approved in November of 2002 by the court (Bertelsmann was apparently locked out of the process despite a higher bid because the judge believed Napster’s CEO, a former Bertelsmann employee, had colluded).

About six months later, in May 2003, Napster got a second chance at life when Roxio bought Universal Music and Sony Music joint venture "Pressplay" for about $40 million in cash and stock. Explained Roxio CEO and Chairman Chris Gorog at the time, "With our acquisition of Napster we obtained the most powerful brand in the online music space. Now with our acquisition of Pressplay, we have the most complete and scalable legal technology infrastructure to use as a platform to relaunch Napster."

With the marriage to Pressplay, Napster 2.0, the Roxio version, was officially resurrected as a licensed music service; a potential rival to a then still young iTunes.

Less than a year later, in December 2004, Napster dodged another bullet. Roxio, apparently in need of cash to support the music business, struck a deal to sell its software business to Sonic Solutions (SNIC). Napster, which wasn’t included, became its own company for the second time in the brand’s short life.

In the years since, Napster largely struggled to make it as a primarily subscription-based digital music service - an all-you-can-eat buffet built around a recurring monthly fee. The problem, as was the case with many rivals, was the closed market of copyright protection systems the record industry insisted be used. And as has been well documented, the use of these DRM tools (and the way the contract guided their implementation) helped create an island ecosystem. Apple (NASDAQ:AAPL), as one example, had no incentive to share their proprietary Fairplay encryption system with the market. Just the opposite, contractual obligations made it in Apple’s best interests to keep the encryption scheme private. The result: Napster (and everyone else in the space) had no bridge to Apple’s iPod. They couldn’t sell music playable on the most popular device (by a staggering margin) in the market. The opportunity for success, as a result, was severely retarded.

It wasn’t until last Spring, May 2008, that a bridge was finally built. At that time, DRM-Free music capable of playing on any device (including the iPod) was added to Napster’s portfolio of services in an a la carte formula (e.g. they sell single songs and albums in DRM-Free MP3 format). The service was offered in addition to their classic subscription service which remains encrypted and is not iPod compatible.

Unfortunately for the company, the DRM-Free offer was largely too little too late for them to stand a chance of chasing down Apple’s (5 billion plus songs sold) music selling juggernaut.

Best Buy's Buy

In buying Napster, Best Buy has agreed to pay a paltry $54m, or an amount equal to $2.65 a share, plus $67 million for cash and short term investments. The total value of the deal is approximately $121million. (Note: Napster’s outstanding shares as of August 8th, their last quarterly report, were 47.9 million which would suggest a slightly higher price. Best Buy has said the difference is the result of unvested stock options.)

The deal will require regulatory approval and standard closing conditions. According to the SEC filings (available here and here), Napster faces a $3m breakup fee if they walk.

Senior managers including CEO Chris Gorog, President Brad Duea and COO Chris Allen have signed employment agreements as part of the deal that will keep them with the company until 2012. Base compensation will run $400k for Gorog, and $315k for the other two. Full compensation details are available in the filing (item 5.02, available here)

Best Buy’s Napster

$56m (or even $121m) is a meager sum for a company with more than $1.4b in cash, quarterly revenue above nearly $9b or quarterly operating income above $275m (source). But Napster by Best Buy, or whatever they choose to call the newest Napster, is likely much more significant than the price might appear.

Big box retailers like Best Buy have been seeing digital sales (e-commerce and digital downloads) erode CD sales for years. In August, NPD reported that for the first half of 2008, iTunes was the nation’s top music seller. When the original Napster was first launched, that would have seemed unfathomable. iTunes didn’t even exist. Today, it’s the top of the food chain. Amazon (NASDAQ:AMZN), on the strength of its download service and the fact that physical sales online are eroding more slowly than at brick and mortar stores, has moved up to fourth place.

Wal-Mart, Best Buy and Target (NYSE:TGT) (2nd, 3rd, and 5th respectively) can’t afford to lose their standing without a fight. That’s especially true if the DVD business eventually gives way to downloads as many expect it will within the next five years. Billions in earnings, not to mention crossover promotional potential, are at stake.

In buying Napster, Best Buy is buying a tool and known brand to forestall a future migration to competing digital distributors. To look at this deal solely in the context of Napster’s more widely known subscription service (which is relatively weak at about 700k subscribers) is short sighted.

This deal is bigger than music. Like Blockbuster’s (BBI) pennies on the dollar purchase of Movielink, Best Buy’s acquisition of Napster gives a traditional retailer an in-house technology development department with a ready to go technology and, at the same time, of equal if not greater importance, a ready licensed library of downloadable digital content.  

Many may not be aware but Napster launched a broad online MP3 store last May. The "Napster lite" offering was (per their press release at the time) "50% larger than any other MP3 store and boasts not only the largest major label MP3 catalog in the industry, but also the largest library of independent music available anywhere." This library, assuming the licenses are transferable to Best Buy (which they presumably are), is potentially very valuable.

Napster also has an active mobile service that streams music and video content to mobile customers. It’s lesser known in the U.S., and may be less relevant, but it could also be interesting. It launched in Japan with mobile operator Ntt DoCoMo (NYSE:DCM) last Spring too.

As part of Best Buy, the MP3 store potential, and the prospect of bundling music with hardware sales are the real stars in the acquisition. They are a significant expansion of Best Buy’s current music store service (currently powered by Rhapsody).

As Best Buy President Brian Dunn put it in the official release: “This transaction offers Best Buy a recognized platform for enhancing our capabilities in the digital media space and building new, recurring relationships with customers.” He added, “over time we hope to strengthen our offerings to consumers, who we believe, will increasingly seek devices and solutions that enable them to access their content wherever, whenever and however they want.”

Napster subscribers and thirty-odd million dollars (Q1) in sales additions aren’t the story. The story is bundling and direct sales.  To be able to sell an iPod or a new phone with ten free MP3s included is a valuable promotional tool. The same is true for offering a computer preloaded with Best Buy branded services (Napster has a deal with Lenovo). With Napster, Best Buy gains those abilities and more.

So…. if Napster 1.0 was the rebellious teen years and Napster 2.0, the subscription service, was the misdirected twenties, then Napster 3.0, the Best Buy variation, may be the focused thirties. It’s the prospect of the company reinvented as a product marketing magnet.

After proving itself a survivor again and again it will be interesting to see how the company adapts to life inside the box of a big retailer.

Source: Best Buy's Napster Will Fuel Bundled Music Offerings