Should ATRN Spin Off Kazaa in an IPO?

| About: Atrinsic, Inc. (ATRN)
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Should Atrinsic's (Nasdaq: ATRN) board consider floating a minority stake in Kazaa in a spin-off IPO transaction where Atrinsic would continue to own and operate the company? Over the last 10 days, several news items have shed light on the value professional investors see evolving in the on demand streaming music space. European "on demand" streaming music leader Spotify added its largest financing round yet, reportedly taking in $100 million from the high profile "winner-picker" Russian firm DST. The $100 million figure alone has drawn much attention given that this venture round essentially allows them to take down just as much as Pandora is seeking to raise with its IPO. However, the eye-popping part of the deal was that it reportedly only got it a 5% stake - valuing the entire Spotify enterprise in the $2 Billion range.

Less than one week later, it was reported that US based on demand streaming competitor MOG was in the process of raising $25m - $30m in a follow up round to the $10m it raised last year. This could potentially double the $25m funding it has already received and while the terms were not disclosed, it seems fair to assume that this round is at a minimum valuing the company in the $50m range (otherwise the marketplace would be abuzz discussing their "down round"). The most interesting part of the news to ATRN holders were the growth projections from MOG management, who are reportedly predicting that they can achieve revenue up to $14 million for calendar year 2012. As would be expected, this would represent significant growth from the what is reportedly a current subscriber base of around 20,000 users.

While it may be optimistic at this stage to suggest that an IPO of Kazaa might achieve a valuation in the $50m+ range, these two events suggest it could be possible for demand for Kazaa shares to push the valuation to that level or even higher. Ostensibly, venture capitalists and institutions able to take part in funding at this stage for companies like MOG and Spotify represent the "smart money" and they are more likely to require significant discounts for the lack of liquidity inherent in an investment at this stage. If they are willing to invest in MOG at a valuation approaching $50 million, what might they pay to invest in a nearly identical company with 2x the subscription revenue of MOG, 3x the number of subscribers that MOG reportedly has and a much stronger consumer brand name than MOG? When the liquidity discount of venture funding is removed and the opportunity is presented to retail investors instead of VCs, a $50m post Kazaa IPO valuation seems not only reasonable, but downright cheap.

When viewed in light of the Spotify valuation, Kazaa at $50 million looks even cheaper. Spotify reportedly generated revenue in 2010 of about $134 million, which is about 7x the subscription revenue that Kazaa is estimated to have produced for that same period. Spotify reportedly finished 2010 with around 650,000 subscribers, which is around 10x the size of Kazaa's last reported subscriber base. Given these two key metrics, it seems reasonable to suggest that Spotify would be worth 7 - 10x as much as Kazaa, though we would argue that Spotify's meteoric growth rate would make it worth even more than that. If we double the high end of that range and say Spotify is worth 20x as much as Kazaa, the recent $2B valuation for Spotify would allow us to back into a Kazaa valuation somewhere in the $100m range. One interesting consideration to be made there though is that Kazaa already has the US licenses from the four major labels that Spotify, Apple (Nasdaq: AAPL) and Google (Nasdaq: GOOG) are reportedly finding it so difficult to obtain.

While it would be speculative at this point to suggest 1) that the board will decide to move forward with a Kazaa IPO and 2) that it would result in a total valuation (post IPO) in the $50m - $100m range , we think the recent fundings of its competitors, high profile (Sean Parker in Spotify, Janus Friis & Niklas Zennstrom inRdio ) entrepreneur investments in the white hot streaming music space and Wall Street attention that is starting to be focused on this space suggests that ATRN's board would do well to consider floating a minority Kazaa stake in an IPO spin-off transaction. While there would be additional expense in such an undertaking, the value of offering the first pure play investment vehicle for the on demand streaming music space and the financial flexibility it would create for both of the resulting companies (Kazaa and Atrinsic) would seem to justify it several times over. Kazaa would have a very highly valued currency with which it could acquire smaller players in the space whose subscriber ranks and/or technology the company found appealing. Atrinsic Interactive (who would see the value of its stock soar due to its stake in Kazaa) would be able to use its newly high valued stock as acquisition currency to scale its business much more rapidly. While we know that bankers do not typically battle each other to bring a sub $25m deal to market, we believe they will see this as an opportunity to establish relationships in a white hot space where we should see several more IPOs (Spotify, Rhapsody, etc.) and significant consolidation over the next 12 - 18 months. We also note that the smallest deals of the past two years ($9.4m in 2009 and $10.2m in 2010) were placed without such an appeal.

One last thought - a couple of weeks ago I wrote in an article that we believed that short selling had swelled from the Feb. 28 Nasdaq reported figure of 4,600 shares to as much as 350k- 400k shares of ATRN by the middle of March. The official ATRN short position as of the close on March 15, as reported by Nasdaq on Friday was 329,051 shares. It appears that the sell off in ATRN shares on March 14 and 15th allowed many to cover their position before that report was tallied. We believe that the trading action since that time indicates a much larger short interest is now in place and that it is quite likely that more than 50% of the true public float is now sold short.

We find this to be somewhat remarkable when you consider that ATRN stock only traded an average of 4,000 - 8,000 shares per day in the previous Nasdaq short interest / volume reports and even more remarkable when viewed in light of the recent funding valuations for competitors that suggest the Kazaa assets alone could be worth more than $10 per share to ATRN regardless whether the board chooses the spin off approach. ATRN obviously has turned into a focus point for short sellers and one has to wonder how they will respond to these recent marketplace valuations that suggest a business like Kazaa could be worth as much as $100 million in a spin off even though more than half of its free trading public float may have been sold short at a valuation less than one fourth of that.

Disclosure: I am long GOOG.

Additional disclosure: Author is also long ATRN. This is a follow up story to one posted several weeks ago about ATRN and the online music space.