Monday, January 23, 2006

RealNetworks--Skip this Digital Party

Two years ago, a fledgling RealNetworks, Inc. (RNWK-$8.19) , before it had 2.2 million paying subscribers, and before it became a leader of digital media services and software, including Rhapsody, RealPlayer 10, and casual PC games, filed suit against Microsoft Corporation, alleging that Microsoft had illegally used its monopoly power to restrict competition, limit consumer choice and had attempted to monopolize the field of digital media. Specifically, RealNetworks sought relief of more than $1 billion in damages, claiming that Microsoft had withheld information about the Windows operating system that made it more difficult for RealNetwork's to make its RealPlayer compatible with the world's most popular desktop platform.

On October 11, 2005, the Company and Microsoft entered into an agreement to settle all antitrust disputes worldwide between the two companies. Upon settlement of the legal disputes, the Company and Microsoft entered into two agreements that provided for collaboration in digital music and casual games:

  • Microsoft will pay $460 million in cash to RealNetworks to settle all claims and give Real long-term access to Windows Media technologies to settle the antitrust issues worldwide. Under the settlement agreement, RealNetworks agreed to dismiss its antitrust litigation in the United States against Microsoft with prejudice and agreed to take no further steps to participate in the antitrust proceedings pending against Microsoft instituted by the European Union and South Korea. In addition, pursuant to the settlement agreement, Microsoft and RealNetworks entered into a technology assurance pact. RealNetworks will receive more access to Windows code to enable it to build more compatible software. Microsoft has also ensured RealNetworks broad access to Microsoft's PC OEM distribution channel, and the two companies have also contractually agreed to work together to enhance interoperability between Microsoft’s Windows Media and RealNetworks' business Helix Digital Rights Management (DRM) systems (which enables RealNetworks' commercial customers to create and deliver their own digital media applications and services).
  • RealNetwork's will also receive another $301 million in cash scheduled to be paid quarterly over 18 months related to a collaborative music and games agreement. Microsoft agreed to enter into a "wide-ranging digital music collaboration" that includes promotional and marketing support of Real's Rhapsody subscription music service on the MSN portal. In addition, RealNetwork's digital video games will be promoted through both MSN Games and the Xbox Live Arcade for Xbox 360.
  • When the deal was announced, business headlines and investor message-boards alike crowed about this big win for RealNetworks: "Microsoft Settles Suit for $761 million!" ... And, the bulls promulgated BIG things to come for this digital music provider. Yes, in the short term, the agreement is a win, for it lets RealNetworks escape the onerous legal expenses, which corporate says have precluded profitability in several quarters since it filed the suit, which--to date-- has cost it $22.9 million. [ed note. Contrary to "corporate speak," litigation expenses were NOT the only reason the Company has not shown operational improvement. From the third quarter 10Q filing--To quote management: "In addition, our sequential revenue was adversely impacted by slowing growth of our premium music subscription service revenue."

The 10Q Detective hates [sure we do!] to break up a good party...but let's read a bit more from the aforementioned SEC filing: "....Our revenue growth was also impacted by an increase in the number of customer cancellations attributable primarily to our increasingly large subscriber base." [ed. note. Again more corporate speak--Management is telling us that the churn is a numbers game--the more customers who join--the higher the probability that more will quit, too]. "Finally, our Music business continued to face intense competition in the third quarter of 2005 as certain marketing channels became more crowded with competitive offers of lower prices. We currently anticipate that these trends and factors, particularly slowing growth of our premium music subscription service revenue, will result in slowing sequential revenue growth in the fourth quarter of 2005 as compared to prior periods." [The 10Q Detective calculated that for the nine-months ended September 30, 2005, Music-related services contributed approximately 35 cents to every dollar in top-line sales.]

Now back to the festivities....The champagne being drunk--Wall Street analysts and investors are now gossiping: What will the Company do with all this money? One, why not price and market Rhapsody music service aggressively (as a loss leader?) to compete and take some market share against Apple's iTunes Music Store, Yahoo! and Napster? According to a recent report by the International Federation of the Phonographic Industry, however, the digital downloading and streaming services market is intensely competitive, with some 355 other online premium music sellers.

Second. How about doing a few horizonal acquisitions? It would be easy for corporate to calculate acquisition cost per subscriber (ACPS) in a buyout compared to the costs of organic growth. For example, Napster, Inc. (NAPS), better known as the (once) free file-sharing network that helped popularize the digital music industry, has an enterprise value of $8.9 million. Even if RealNetworks paid a 20% premium to market, it would still only cost the Company $21.36 in ACPS to acquire an additional 500,000 subscribers [excluding churn]. RealNetworks does not breakdown its ACPS; instead, it lumps it together in Sales and Marketing expenses with the likes of salaries and related personnel costs, sales commissions, consulting fees, etc. Historically, corporate has declined to reveal practically anything about what RealNetworks has learned about selling subscriptions--and the related ACPS, too. For the stated nine-month period, Sales and Marketing expenses trimmed 39% from net revenue. That said, we are comfortable stating that RealNetworks' ACPS is probably in the range of (at least) $100 per subsciber.

Of interest, too, RealNetworks' 10Q filing for the three-months ended September 30, 2005, revealed music-related sales of more than $25 million--yet corporate still declines to say whether or not this "renter" platform (monthly fee for unlimited downloads) is profitable [as say...compared to Apple's "Buyer"/per download business model].

Third. Other analysts expect corporate to either increase R&D spending on the mobile content side, both on technology and on specialized, content development--or buy the treats they need to stay competitive. For example, in 2003, RealNetworks spent approximately $36 million to acquire Listen.com and its highly-regarded RHAPSODY subscription service, which came with assets the Company needed to build the music offerings of RealNetworks' RealOne subscription service.

Enough speculating--what has corporate announced to date to enhance shareholder value?

  1. 1. $40 million to $50 million is earmarked for contingent legal fees and other litigation costs.
  2. 2. On November 4, 2005, the Compensation Committee of the Board of Directors approved cash bonus awards to certain executive officers of the Company. Roy Goodman, the Company's Senior Vice President, Chief Financial Officer and Treasurer, will receive a cash bonus award of $50,000, and Michael Schutzler, the Company's Senior Vice President, Media Business, will receive a cash bonus award of $25,000.
  3. 3. On November 30, 2005, the Company granted cash bonus awards to a select team of employees for their efforts related to the aforementioned settlement and collaboration agreement. Only two of these VERY important employees were mentioned by name: (1) Robert Kimball, the Company's General Counsel and Corporate Secretary, received $1 million on November 30, and will receive an additional $1.5 million if he sticks around through November 30, 2008 (why leave)! (2) Daniel Sheeran, the Company's Senior VP, Premium Consumer Services, received a cash payment of $70,000 on November 30, 2005, and will receive cash payments of up to $65,000 in each of May 2006 and November 2006. Bob Glaser, CEO, Roy Goodman, CFO, and Dick Wolpert, Chief Strategy Officer--the 10Q Detective is comfortable in saying that these three are probably among the VERY important people selected to receive sugar-sugar rushes from the $460 million cookie jar, too.
  4. 4. December 06, 2005 — RealNetworks announced that the Board of Directors had approved--in the amount of $100 million--a stock buyback program. Repurchases may be made in the open market or through private transactions, in accordance with Securities and Exchange Commission requirements. So not only do the insiders take from the $460 million once--but they get to double-dip in the cookie jar if market conditions permit! By the way, the trailing twelve-month return on shareholder equity for RealNetworks was a meager 4.06 percent. Ten-year treasuries, currently yield 4.36%--with no risk to principal.

Add up all the DISCLOSED line items, and that cookie jar shrinks to about $260 million.

Oh, and that $301 million that RealNetworks is still owed, read the fine print and you'll notice that Microsoft earns credits--'finder's fee'--for every new Rhapsody subscriber who arrives from MSN. The agreement does not preclude Microsft from continuing to solicit a new pool of subscribers for its own online music and gaming services, too.

Is RealNetwork's business model economically viable in the long-run? The digital music party has legs, but given the apparent greed by insiders, building a competitive competence does not seem to be a top priority right now. The 10Q Detective likes RealNetworks' products, but until corporate stops stuffing its [collective] faces, we are going to avoid this party.

Sun Tzu, The Art of War, said: "...a wise general strives to feed off the enemy." RealNetworks should heed his advice.

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