Napster F2Q07 (Qtr End 9/30/06) Earnings Call Transcript

| About: Napster Inc. (NAPS)
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Napster, Inc. (NAPS)

F2Q07 Earnings Call

November 8, 2006 5:00 pm ET

Executives

Alex Wellins - The Blueshirt Group

William C. Gorog - Chairman of the Board, Chief Executive Officer

Nand Gangwani - Chief Financial Officer, Vice President

Analysts

George Sutton - Craig-Hallum Capital

Darren Aftahi - ThinkEquity Partners

Leland Westerfield - BMO Capital Markets

Ingrid Ebeling - JMP Securities

Operator

Good afternoon, ladies and gentlemen, and welcome to the Napster second quarter conference call. At this time, all participants are in a listen-only mode. Following today’s presentation, instructions will be given for the question-and-answer session.

(Operator Instructions)

As a reminder, this conference is being recorded today, Wednesday, November 8, 2006.

I would now like to turn the conference over to Mr. Alex Wellins with The 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 shared financial results for its second 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.

I would like to remind you that during the course of this conference call, Napster management will make forward-looking statements, including predictions and estimates. These statements, including any statements regarding the expectation for future revenues, operating costs and net losses, growth of the Napster free and paid music services, the growth and sales of music-enabled cell phones and the effect of such growth on the Napster business, interoperability with popular music playback devices, relationships with wireless carriers, including Cingular and DoCoMo, strength of the Napster brand, potential strategic transactions, and the growth and potential mass adoption of digital music subscriptions in general, 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 10-Q for the quarter ended September 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 will turn the call over to Chris.

William C. Gorog

Thanks, Alex, and thanks, everyone, for joining us on the call today. Napster posted revenue of $25.5 million for our second quarter of fiscal 2007, up 9% from a year ago, while at the same time, we significantly reduced our cash burn during the quarter.

We are also pleased to report that Napster.com’s unique visitation grew 42% in the second quarter, which provides us with the opportunity to continue to grow our new ad-supported free music service and simultaneously deliver positive paid subscriber growth through the balance of our fiscal year.

Recent highlights in our development include a very successful launch of Napster Japan, which now places Napster in each of the top four music markets in the world, expanding on our position as the leading global music subscription service.

The last 10 days have been exciting and very busy, as Napster Mobile launched with both Cingular, the largest mobile carrier in the United States, and with NTT DoCoMo, the largest mobile carrier in Japan, delivering on our promise of deploying on the top-tier global wireless networks.

We believe the dramatic growth projected for music-enabled cell phones will provide a very significant growth driver for Napster going forward. I look forward to providing more details on our mobile activities, as well as other recent developments.

First, I will ask Nand to walk you through our financial results.

Nand Gangwani

Thanks, Chris. Good afternoon, everyone. As Chris mentioned, Napster reported revenues for the second quarter of fiscal ’07 of $25.5 million. This was above our guidance, and represented growth of approximately 9% over the prior year period.

Second quarter revenues included approximately $600,000 in non-recurring promotional breakage revenue.

Revenues from international, including the U.K. and Germany, represented approximately 19% of revenue for the quarter.

As of September 30, 2006, Napster’s total paid subscriber base was 518,000. This includes 31,000 university subscribers, up from 4,000 last quarter following the summer break. Excluding university, the number of paid subscribers grew 20% year over year, but decreased 4% from the first quarter based on the transitional impact of our free music service and summer seasonality.

Gross margin, including non-recurring breakage revenue, was 27% for the quarter, versus 32% for Q1. Excluding breakage revenue, gross margin was 25%, down two points versus Q1, reflecting a full quarter of expense for the free site, increased encoding expenses, and increased lower margin hardware shipments for the second quarter.

Operating expenses for the quarter totaled $16.5 million, down significantly from $19.4 million in the prior quarter, mainly as a result of controlled marketing spend.

On a line item basis compared to the prior quarter, R&D spending decreased to $2.3 million from $2.9 million, as we were reimbursed for non-recurring engineering expenses from our Japan joint venture.

Sales and marketing expenses decreased to $8.5 million from $10.5 million due to controlled spending in both North America and Germany.

G&A decreased slightly to $5.7 million from $6.0 million, primarily due to year-end tax consulting and audit expenses included in the first quarter.

The loss from consolidated entity of $338,000 reflects our portion of the loss from our joint venture with Tower Records Japan.

GAAP net loss for the second quarter was $9 million, or $0.21 per share, favorable to our guidance for a loss of $0.30 per share.

Napster ended the period with 154 full-time employees.

Moving to the balance sheet, we ended Q2 with $90.3 million in cash, cash equivalents, and short-term investments.

Now, over to guidance. We expect to grow revenues during the December quarter based on typical seasonality, and as we begin to move past the transitional issues related to our free service. Additionally, we expect to record approximately $2 million of non-recurring revenue related to prepaid card breakage and development fees paid to us for the Japan launch on October 3.

We currently anticipate quarterly revenue will exceed $27 million, and expect to see continued improvements in our key operational metrics.

We expect fiscal Q3 operating expenses to return to Q1 levels, as we plan to increase our marketing spend to take advantage of seasonality, and as we step up promotional campaigns leveraging MP3 device bundles.

We are projecting a net loss for the third quarter of approximately $13 million, or $0.30 per share.

Based on our results to date, and expectations for a solid second-half of the fiscal year, we continue to expect to end fiscal ’07 with double-digit year-over-year revenue growth.

I appreciate your attention. Thank you, and now, over to Chris, who will bring you up to date on recent developments.

William C. Gorog

Thanks, Nand. Let’s begin with an update on our PC services before turning to new developments on the international and mobile fronts. Our advertiser supported free music service offered at Napster.com continues to make good progress. As mentioned, unique monthly visitors increased 42% quarter over quarter, with an average of 3.5 million unique visitors per month. This is up from an average of approximately 2 million monthly uniques prior to our launch of the free service.

Napster's highly desirable demographics and strong usage statistics have continued to attract top-tier, high CPM clients, such as Intel, HBO, Disney, Toshiba, and many others, and we grew ad sales considerably over the quarter.

While the introduction of our free music service, as predicted, has slowed the growth of our paid business, it has helped us deliver on improving two critical economic drivers for our business model. Our subscriber acquisition cost is down quarter over quarter, and churn continues to decline, and is currently at our historical low.

Seeing improvements in these critical metrics together with healthy growth in monthly unique visitation encourages us that we are on the right track by introducing a free product and working to achieve the best balance between the introductory free experience and the upgrade to the paid experience.

Frankly, we are still working out some of the kinks in terms of how these two experiences best work together, but we think a combination between a free and paid experience is where our industry is heading and believe it will prove to be very valuable as we continue to innovate with our model.

Turning to international, our launch of Napster Japan was very successful. As most of you will recall, Napster Japan is a joint venture with Tower Records Japan, which is the leading music retailer in the country, and NTT DoCoMo is its largest shareholder.

We kicked off the launch on October 3rd with a press conference attended by more than 250 members of the media, which included participation from DoCoMo, Toshiba, Microsoft, and JVC.

Napster Japan launched with close to 2 million songs in its catalog, including content from both the global majors and the Japanese majors.

The Napster Japan launch was one of the biggest and loudest in our short history. The press provided the backbeat with very broad coverage, expressing great enthusiasm about the return of the Napster brand and the entry of the first music subscription service to Japan.

The launch was supported with extensive television, press, online and outdoor advertising, as well as retail availability of Napster products in over 35,000 storefronts throughout Japan.

DoCoMo also supported the launch extensively, including an exciting promotion at CREATEC, Japan’s largest consumer electronics show. The most impressive aspect of our Japan launch, however, was clearly the in-store execution by Tower Records Japan’s 82 music stores. After witnessing U.S. retailers stumble in their efforts to market digital music, it was eye-popping to see Tower Records Japan’s retail execution, including massive exterior signage, in-store Napster lounges, kiosks, listening stations, and integrated presentations of compatible and bundled MP3 players and cell phones.

The Japan launch has exceeded our highest expectations in terms of unique visitors, conversion to trialers, and paid subscribers. The sheer size of this brand based launch once again illustrates the unique power of the Napster brand.

Ipsos Insight’s just published quarterly digital music brand study shows Napster once again the most recognized brand in the industry, continuing to outpace iTunes and dramatically outpacing Rhapsody, our closest competitor in the subscription space.

Napster brand power gives all of our partners, be they retailers, hardware players, or wireless carriers, a substantial leg up when they attach their initiatives to the most recognized brand in the space.

The very high profile launch of Napster Japan’s PC music service set the stage for this week’s high profile launch of Napster Mobile with DoCoMo, which leads me now to our mobile discussion.

As we get into looking at the mobile opportunity today, it is important to understand that while we believe the potential for our new Napster Mobile products, such as over-the-air downloads and ringtones, is substantial, we are particularly excited about how top wireless carriers can help us propel the growth of our core paid PC based subscription product, Napster To Go.

Both Cingular and DoCoMo believe offering their customers the ability to side load portable PC subscription music, such as Napster To Go, on to their cell phones offers an exciting killer app not currently in the market with any wide availability.

Napster's growth, over the last year in particular, has been restricted by not being able to attach to the closed system iPod. This barrier is in the process of being lifted. Cellular News last week featured a story called “Mobile Phone Players Could Challenge iPods”. Based on a study from Continental Research noting that consumers like using the MP3 capability on their cell phones, and of those that do, 70% use that function at least once a week.

While the broad availability of music phones is only just beginning, Cingular now projects by the end of 2007, 50% of their handsets shipped will be music-enabled. Strategy Analytics says music phones shipped by 2009 should reach 800 million units.

Here is the critical point: Cingular, DoCoMo and many, many more global wireless carriers and global handset manufacturers are building their music technologies on the Windows Media DRM platform, which means that Napster is beginning to move from a virtually non-existent addressable market in portable devices to the ability to attach to hundreds of millions of music-enabled cell phones over the next few years, and we are addressing this opportunity as the number one or two player in the Windows Media digital music space.

Jim Ryan, Cingular VP of Consumer Data Services, told Billboard last week in regard to Cingular’s strong bet on marketing digital music subscriptions: “We will solve the problem of digital music subscriptions and we will make a whole new business paradigm. We can double their base in the next 12 months.”

The data points are beginning to pop up everywhere, supporting that our ubiquitous friend, the cell phone, will soon also become our MP3 player, and why not? Many of us are constantly searching for ways to eliminate multiple devices and combine functionality. Even the CEO of SanDisk, the maker of the number two MP3 player in the market, noted in this morning’s USAToday, that: “There is always going to be room for standalone players, but the sheer numbers favor handsets.”

As most cell phones become capable of and marketed to be successful with portable subscription, adoption should soar. The digital music subscription industry has needed a powerful catalyst to cross the chasm into mass adoption. We believe that the extremely fast-moving ecosystem that is coming together of hundreds of millions of Windows Media DRM compatible cell phones will be the tipping point for our industry.

It is starting to tip as we speak.

This very significant structural change in digital music looks to be very important for Napster, but it can only be maximized by tightly integrated technology and marketing partnerships. So in this regard, let’s take a look at our relationships with these two huge carriers, starting with DoCoMo, which Napster Japan launched with last week.

DoCoMo is the leading carrier in Japan, with 54 million subscribers and over 50% market share. DoCoMo is marketing the Napster To Go PC subscription service to their wireless customers on multiple NTG compatible handsets for manufacturers including Fujitsu, Sharp, and Mitsubishi.

This week, Napster Japan also launched with DoCoMo our over the air products, including full length downloads and ringtones through a new subscription plan of approximately $3 per month.

40 million customers are already signed up for DoCoMo’s premium data product, called iMode, which is an extremely large and very easily addressable market for the Napster Mobile products. DoCoMo has created a very aggressive campaign highlighting Napster, as well as the Napster To Go PC to handset side loading capabilities, through a multi-million dollar integrated campaign comprised of TV, outdoor, print, in-box, online, and on-deck promotion, marketing Napster as DoCoMo’s recommended music product.

To sum up where we stand with this partnership, DoCoMo’s managing director of multimedia services said at their launch press conference quite simply: “DoCoMo’s music strategy equals Napster.”

Obviously, this type of deep commitment to our brand is the ideal, and we will try to replicate it, or close to it, as much as we can.

In the U.S., while Cingular, the nation’s leading carrier with 57 million subscribers, has chosen to also make available some competitors’ products, Cingular is featuring Napster. Napster is the only music service being promoted in box with Cingular’s current music subscription phones. Napster Mobile is presented in the highly coveted number one position in on-deck placement on all Cingular music handsets.

Napster is also being promoted in a preferred manner on Cingular’s website. Cingular is not only marketing Napster To Go and featuring Napster with each compatible handset sold, but Napster is also the only music service integrated into Cingular’s unique music ID recognition service, where Cingular’s customers can literally hold their phone up to music, listen to it, and identify music tracks anywhere, and then purchase them with Napster. It is a really cool feature.

Our mobile service with Cingular launched on Monday, with handset initiated PC downloads, which will lead to over the air downloads next year. The first compatible Cingular phones to ship with Napster bundles are from Samsung, which are shipping this week, and many more models will follow from Samsung and other manufacturers.

So as you can see, our integrated promotional activity with both DoCoMo and Cingular is very extensive, and we expect great results. We will continue to aggressively expand the footprint of Napster Mobile, and we will be increasing our lead further in this critical space with additional carrier announcements before the end of the year.

It is worth taking a quick step back to ask, how has Napster positioned itself so well in mobile to the point that Variety says: “Napster is clearly ahead of its competitors.”

A big part of the answer, of course, is brand, but the unsung hero here is that we control our own back-end infrastructure, and can therefore adapt and move very quickly in implementing these exciting new technologies.

Most of our subscription competitors lease their back-end technologies from a third party, and are frequently hamstrung in addressing fast-moving technology-centered opportunities. Our control over our back-end infrastructure results in our having control over our future, and this continues to prove itself to be a significant competitive advantage.

In wrapping up my comments today, and as we head into the second-half of fiscal 2007, it comes easily to say we are more optimistic about our business than we have been in some time. It would be difficult to overstate how important we believe the Windows Media DRM music phone ecosystem will be to catalyzing the growth of our business. We hope you can see that Napster is very well-positioned to benefit from this opportunity.

The front page headline of USAToday’s money section states today: “Portable music’s future could be your phone. Trend expected to catch fire soon.”

Napster has been a pivotal player in the development of this trend, and we are very excited to maximize our significant partnerships to grow with this new wave of adoption.

Now, before moving on to Q&A, I would like to make just a quick comment about our recent engagement of UBS. While I am sure you are all curious about this process, I know you will respect that we cannot address any questions whatsoever about prospective M&A activity, valuations, et cetera. I will only reiterate that we have received interest from third parties and have engaged a banker to help assess these options. We believe Napster's prospects are exciting as a standalone, and we are also intrigued about potential strategic combinations.

The Board will evaluate all options before us and come to a decision with a goal of enhancing shareholder value.

As stated in our press release regarding this activity, we have set no definitive timetable, there are no assurances that this process will result in a transaction, and we do not intend to disclose developments unless and until there is something to announce.

Please understand that if you do ask any question whatsoever in this regard, we cannot engage in any discussion today.

Thank you so much for your attention this afternoon, and now, to your non-M&A related questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question is from George Sutton with Craig-Hallum Capital.

George Sutton - Craig-Hallum Capital

Good afternoon, guys. Chris, you had an interesting quote that you used, and that was that the mobile side of the market could double the base over the next 12 months, and that was, of course, I understand somebody speaking about your current platform. Is that rational in terms of timing? Could you give us a sense of when you really expect mobile to begin to catch some revenue fire?

William C. Gorog

Sure, George. Thank you. Obviously, when the head of Data Services at Cingular talks about the possibility of doubling our business and the size of the digital music subscription business over the next year, it is very exciting, because I think he is coming from a pretty informed place.

Obviously we do not make projections with respect to our subscriber base. I would only say that we do fully expect to make material contributions to our revenue next year from the mobile space. I really cannot overstate in a general way how significant we think this trend is, but we are going to be a little cautious about quarter to quarter, and even year over year in terms of how fast this up-take really propels our business. It all seems to be green lights and extremely exciting, but I think the only quantification I can really give you is that we do expect significant and material revenues from mobile next year.

George Sutton - Craig-Hallum Capital

For this holiday season, you are I would say somewhat aggressively promoting your own player as an enticement for both current and potential subscribers. You have said in the past that you recognize that is a tough way for you to compete. I am just curious, how much cash are you willing to put against that part of the program for the next few months?

William C. Gorog

Well, the good thing about this one, George, is that we already have experience with these kinds of self-created MP3 player bundles. We have been working with this manufacturer now I think for over a year. We have a very controlled method of making sure we do not get sacked with a bunch of inventory risk, and it seems to frankly be a very low-risk way for us to create a lot of value for new subscribers.

I think it is a very effective marketing tool because we are making it easy for new prospects to enjoy Napster for the first time. So instead of signing up for Napster and then going into retail and trying to find someone knowledgeable to recommend a player within their budget and so forth, we really handle it with one-stop shopping by providing an inexpensive player or an opportunity to upgrade to a player that we provide.

It works very well for us. Nand, I do not know if you want to make further comment about --

Nand Gangwani

Sure, just to expand on that, George, as you know, we offer a free player if they sign up for three months of subscription. As we have said in the past, during the first three months, which we call the activation period, the churn is pretty high. If you do lock in a subscriber for a period of over three months, the churn goes down pretty dramatically, and that more than compensates for the cost of the device.

In terms of your question whether we are going to spend aggressively, we will be pushing the bundle aggressively, but it is not going to have a very significant impact on the cash front this quarter.

George Sutton - Craig-Hallum Capital

Okay then, last question for me, and it does relate to churn. I was curious if you were referring to that first, that trial customer or whether you were referring to existing subscribers. Could you give us a sense there?

Nand Gangwani

Yes, the activation churn is the churn in the first three months of a paid subscriber. That is the time period in which we see the most churn, and to the extent that we can keep them for a period of more than three months as a paid subscriber, it goes down pretty dramatically, which is kind of the reason why we are pushing this kind of offer.

George Sutton - Craig-Hallum Capital

Let me just rephrase the question. You have two pieces of churn. I understand that. I am wondering, when you say you are at all-time lows in terms of churn, are you referring to both scenarios, both pieces of churn?

Nand Gangwani

Yes, overall. We are referring to the overall churn, which is at an all-time low.

George Sutton - Craig-Hallum Capital

Okay. Thanks, guys.

Operator

Thank you. Our next question is coming from Darren Aftahi with ThinkEquity Partners.

Darren Aftahi - ThinkEquity Partners

Good afternoon, guys. A couple of quick questions. On the Cingular deal, how many handsets are going to be enabled, at least be compatible with your service come the holiday period, December 1?

Second, you mentioned additional carriers being announced by the end of the year. Are these domestic, international, or are they the same sort of magnitude as the two you have recently launched?

Third is a housekeeping question. On the $2 million in non-recurring revenue, I did not quite catch -- that was related to the Japan launch?

William C. Gorog

Okay, Darren, let’s pick those off. Number one, how many handsets will -- how many models I think is your question, will Cingular have out there in the marketplace before the end of the year. I can tell you that right now, we are beginning this week with a model from Samsung, which is an entry-level phone, so it is very competitively priced. I believe it is $49, with the form factor of the Razor, for example, again, produced by Samsung, it is Napster To Go compatible, and we are in every one of those boxes.

I think that Cingular is looking to that device as a hero device this Christmas, and we are very excited about it. Cingular has in their roadmap for the next couple of weeks and months additional handsets from other manufacturers that will be entering the market and be in store that are Napster To Go compatible for the holiday season. I cannot provide you any information on that because of NDAs in terms of specifics.

Secondly, related to this question, I think there are currently multiple Cingular handsets in the market today that are capable of utilizing our over the air product. I think at least four or five, so the people with those handsets today, beginning last Monday, could already access our over the air downloads, listen to 30-second clips, make decisions to purchase songs and ringtones, and have those delivered to their PC.

There are multiple handsets out there that are already doing that with Cingular.

With respect to your second question, we will be adding carriers before the end of the year, and they I think will be viewed as exciting. I do not want to get into the geographics of it right now, if you don’t mind.

The last point is the non-recurring revenue point, and I will turn that over to Nand.

Nand Gangwani

Most of the non-recurring revenue actually comes from prepaid card breakage, so that is basically the prepaid download card that we have sold that have expired and not been redeemed. The reason we are doing it this quarter is we now have enough experience and history to be able to estimate the breakage. Most of that comes from prepaid card breakage.

Darren Aftahi - ThinkEquity Partners

Thank you.

Operator

Our next question is from Leland Westerfield with BMO Capital Markets.

Leland Westerfield - BMO Capital Markets

Gentlemen, good afternoon. First, I respect in principal the advantage of your brand and back-end software and, as you guys have for a long time, I look forward to seeing what is going to happen with the mobile market overall.

I wanted to get a little more clarity on a couple of things related to the ARPU and subscriber dynamics. Over time, perhaps into 2007 roughly, qualitatively, since you are not forecasting, what impact would Cingular and DoCoMo have on your subscriber ARPUs, upwardly or downwardly?

Then, in the September quarter, roughly what fraction of your paid subscriber base was coming out of the U.K. and Germany as opposed to out of the United States?

Then, the final question, Nand, is more balance sheet triviality perhaps, but in the deferred revenue account, it shrank in the quarter. I wonder if you could elaborate on that.

Nand Gangwani

Come again on the last question, Lee?

Leland Westerfield - BMO Capital Markets

Sorry, the deferred revenue account in the balance sheet shrank in the quarter. I wonder if you could elaborate on that.

Nand Gangwani

Yes, the deferred revenues shrank because, as we said in our scripted comments, we recognized about $600,000 in breakage revenue related to some breakage with some bundling activity that we had done in Germany. That is the reason for the shrinkage in deferred revenue.

In terms of the ARPU on subscribers, we will talk a lot more about our mobile economics and how the financials work on that on our next quarterly earnings call. We do think that they will definitely improve the margins and overall health of the business as we get traction on that, but in terms of the exact specifics, a lot will depend upon the traction we get on the different products and services, and kind of what the mix is between the personalization products, ringtones and wallpaper and over the air downloads versus over the air subscription versus side loading subscription.

While we do think that overall the business will be healthier from an ARPU margin and overall business model perspective, I will wait for another quarter before I give more details on that.

In terms of the subscriber ramp in Europe, like we said, 19% of our revenues came from international last quarter. A portion of that is obviously the breakage revenue that we just talked about, so if you exclude that, it is about 16% of revenues coming from international. So our subscriber base closely relates to that, since most of the revenues do come from our subscribers.

Overall, I think international is doing really well. Germany continues to grow very well, and so we are very pleased about that. Going forward, obviously we look forward to the very successful launch in Japan helping that number even further.

Leland Westerfield - BMO Capital Markets

Of course. Chris and Nand, thank you very much.

Operator

Thank you. Our final question is from Ingrid Ebeling with JMP Securities.

Ingrid Ebeling - JMP Securities

Thank you. Good quarter. Most of my questions have been answered at this point, but I was wondering if you could provide some color as to the discussion of the carriers without naming geography, but what about subscriber footprint and the opportunity there?

William C. Gorog

You get points for being clever. I do not want to lead the witness here, Ingrid, other than to say I think that we have made obviously very, very significant traction in the last couple of months in wireless. I guess I would just like to indicate to our investors is that we are not slowing down and we continue to have some big ambition and have a lot of strong interest in what we are doing. We will be making some announcements before the end of the year.

Ingrid Ebeling - JMP Securities

Okay, great. Thanks a lot.

Operator

Thank you. At this time, I would like to turn the call back to management for additional remarks.

William C. Gorog

Thank you all for joining us and we will see you next quarter.

Operator

Thank you so much, sir. Ladies and gentlemen, this concludes the Napster second quarter conference call. Thank you so much for your participation, and have a pleasant day. You may now disconnect.

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