The Key to Realizing Napster's Value

Napster (NAPS) shares have fallen over 20% in recent weeks after a conference call that failed to inspire investors. The company's enterprise value, however, has fallen a staggering 60% in that same time. Some of that may be attributable to short interest that has gone up 50% in two months, from 1.2M to 1.9M.

Amid recent years of iPod domination and recent days of iPhone frenzy stands iTunes, the internet's music download leader with a market share of 70% according to the NPD Group. And still, all along struggling in Apple's (AAPL) shadow has been the puny number two player in the legal music download realm, Napster, who stands at a little over 1/1000th the current market value of Apple.

Yet, puny negative cash flow Napster appears to be a part of the music industry's last hope in not allowing Apple to monopolize and set the terms of legal music download pricing and policy. Just last week, Universal Music Group stated that they would not renew their long term Apple iTunes contract, in an apparent effort to show that they will not be pushed around.

And that's where Napster comes into the picture, claiming to have the most subscribers, over Real Network's Rhapsody, and more subscribers than all the other music download competitors combined. Impressive, when you consider that Yahoo Music in 2005 offered the same service at half of Napster and Rhapsody's price and still haven't been able to catch up.

But how do you valuate an effort to compete with something 1,000 times your size? Here's one way. Napster recently paid 11.2M for 225,000 AOL Music subscribers. That's right. AOL also tried to get in this business and gave up, selling their $10 a month subscribers to Napster for $50 each and making a separate marketing deal for AOL to advertise Napster, in exchange for bounty payments to AOL for each new subscriber.

So if we were to guess that half of Napster's 830,000 subscribers pay $10 and value that at $50 each, we get 415,000 X $50 = $21M. And if we value $15 a month subscribers higher considering the better margins they provide at say $75 each, we get about $31M. Throw in Napster's 66M cash and we get a total base value of about 118M for the net worth of their subscribers and cash. Then you can throw on the Napster trademark, Napster's operational value, Napster's deals with Motorola (MOT), DoCoMo (DCM), Swisscom (SCM), AOL (TWX), Circuit City (CC), AT&T (T), etc. and argue what all of that is worth.

Not much, say recent traders who have brought the market cap down to the 145M. Even though Napster claims to be significantly cutting down expenses (except, of course, for the CEO's 1M a year salary), they continue to lose money. They've cut down marketing with their various partnership deals. But what will it take to make this business profitable?

According to CEO Chris Gorog, the digital download landscape is in the middle of a dramatic change away from the dominant iPod and toward music enabled phones, where Apple will have to compete with other carriers - who are Napster compatible, unlike the iPod.

That's all fine and dandy, but investors are clearly impatient and looking for a quick way to cash out. So in this author's opinion there is an obvious potential buyout partner that would make the move if they knew better. No, not Google (GOOG), or Apple (AAPL), or Yahoo (YHOO), or Real Networks (RNWK), or News Corp (NWS), or XM Radio (XMSR). No.

In a perfect world, the answer to Napster shareholder dreams is Microsoft (MSFT).

Currently, iTunes is front and center on all of Apple's operating systems.

So what about Windows? Where is their version of iTunes?

Microsoft also has something Apple does not have - a major video game console, the Xbox 360, which is known for having the best and most profitable video game online network. Where is their version of iTunes for the home media console?

Oh yeah, have you heard about Zune and Zune Marketplace? No shock if you haven't, because it was Microsoft's thoughtless attempt to copy Apple rather than distinguishing themselves.

Little Napster's subscription music service is a success compared to what names like AOL, Yahoo and Microsoft have done in this space. But will this Megatron of companies even be able to see what little Napster could do for them from up there?

Probably not. But let me try to get their attention from down here: “Hey Microsoft! Zune is a joke. Wake up and buy out Apple iTune’s top competitor. You have the power to make the subscription model work!”

For now, Apple is more than satisfied that their main music download competitor has no buyout partner and is 1000 times smaller. And Napster shareholders may have to think long term – like beyond one year – a very frightening thought for all involved.

NAPS 1-yr chart

Disclosure: none