Napster faces challenges within and without

DENVER (Billboard) - When Napster reported its fiscal first-quarter results in August, it tried to paint a positive picture to investors who were growing increasingly nervous about the company's future.

Revenue had held steady from the previous quarter at around $30 million, the company was enjoying its fifth straight quarter of positive cash flow, and it had recently converted the service to a Web-based system featuring downloads free of digital rights management (DRM). The company that set out to re-create the original Napster experience of unlimited access to music sought to convey the message that it is on the right track.

But investors and analysts haven't seen it that way. Napster's stock bounced off an all-time low in mid-July and is trading at less than half its year-earlier price. Subscriber levels slipped 7 percent from the previous quarter, while the company's fiscal first-quarter net loss widened slightly from the same period last year. And most recently, a group of dissident investors initiated a proxy battle to gain seats on the board.

STRONG BUT STRUGGLING

"It's kind of damned if you do and damned if you don't," Napster chairman/CEO Chris Gorog says. "The bottom line is, five years ago we were No. 2 or 3 in this industry, and five years later we're still No. 2 or 3 in this industry."

Although it has survived the harsh birth of the digital music market when bigger and richer companies failed, the company has struggled to convince Wall Street that an unlimited, all-you-can-eat subscription service is the model of the future.

Despite Napster's efforts to convince music fans of the same, none of its initiatives so far have moved the needle. The addition of Napster to Go mobile devices was tempered by uninspired devices and shaky technology. The napster.com ad-supported free streaming service, which also is meant to replace the now-defunct university outreach program, has been scaled back to a "hidden" unpublicized URL (free.napster.com).

So the focus now is on DRM-free sales and mobile distribution to lure new users. Both efforts have shown encouraging early results. Track sales per subscriber have increased 10 percent from June to July, and overall sales were up 5 percent during the same period. First-quarter mobile-originated sales were up 44 percent over the previous quarter.

"Really for the first time, it puts Napster in a position where we can address all available customers out there," Gorog says.

But he acknowledges that it could take up to a year before these efforts show any material effect on revenue or subscriber totals.

The challenge for Napster is that it may not have that long. The company's shrunken market capitalization makes it an easy target for a takeover. For the second time in as many years, Napster has hired investment bank UBS to field offers. And a group of dissident investors is pushing for board seats to change the company's direction. While these investors together own less than 1.5 percent of the company's stock and have not proposed any specific plans, the proxy battle illustrates the level of investor frustration.

RIVALS ARISE

In the meantime, Napster continues to face stiff competition. Primary rival Rhapsody America is a joint venture between two much larger companies, RealNetworks and MTV.

And new competition from ad-supported streaming sites like imeem and Last.fm, among others, have them both facing the same question: Why would consumers pay a monthly fee to stream songs online when they can use other streaming services for free?

But Gorog downplays ad-supported services as a competitive threat, noting that for all the experimentation going on, none are believed to be profitable.

"We have a $130 million business with 700,000-plus customers and positive cash flow for five consecutive quarters," Gorog says. "So I think the day imeem can stand up and say they're doing business like that is the day I'll pay close attention to what they're doing."

Gorog remains optimistic that music subscription services will have their day, even if it isn't yet clear how they will get there.

"There's no question that the subscription model has not yet reached its potential," he says. "The biggest challenge remains ... to find new, more effective ways to get consumers to understand the benefits of unlimited access to the world's music catalog."

Reuters/Billboard