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Napster faces the music
Shares of Roxio, Napster's parent, have surged lately. But investors should sing another tune.
November 2, 2004: 3:49 PM EST
By Paul R. La Monica, CNN/Money senior writer

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NEW YORK (CNN/Money) - This Election Day, I'd like to celebrate the people's right to choose...their favorite place to download music.

Sure, Apple's iTunes is widely recognized as the king of online music sites. But we live in a democracy, not a monarchy!

Even so, should investors give in to the same choice as consumers? Shares of Apple have surged thanks to the success of iTunes and the iPod music player and I've written several columns about why I think Apple's momentum is sustainable. (For the most recent Apple piece, click here.)

Still, other companies seeking to gain from the growing popularity of digital music might not be as good of a bet.

Take Roxio (Research), for example, the company that owns the now legal music site Napster. Shares have surged about 36 percent this year.

But the company, which will report its latest financial results Wednesday, is expected to report a quarterly loss of 50 cents a share. And Roxio is expected to post losses in this fiscal year, which ends in March, and its next fiscal year as well.

In what is shaping up to be a highly competitive business, Roxio is at a distinct disadvantage to many of its rivals.

Lots of competition

Sure, it has an enviable brand name in Napster -- although there is some debate about whether people still associate Napster more with its days as an illegal file-sharing site -- but Roxio is a small fry compared to its competition.

For this reason, Roxio decided a few months ago to sell its software division to Sonic Solutions for $80 million in an attempt to raise cash. Once the sale is completed, Chris Rowen, an analyst with SunTrust Robinson Humphrey, estimates that Roxio will have about $120 million in net cash (cash minus debt).

But that's a mere pittance compared to the net cash of nearly $260 million for RealNetworks, the owner of Rhapsody, $2.2 billion in cash for Yahoo!, which recently acquired Musicmatch and also owns Launch, and $5.5 billion for Apple.

And oh yeah, did we forget to mention that Microsoft is looking to increase its presence in digital music through its MSN site? Microsoft, even after it winds up paying a special one-time dividend to shareholders early next month, would still have more than $30 billion in cash at its disposal.

Roxio will soon change its corporate name to Napster. But does that justify the stock's surge?  
Roxio will soon change its corporate name to Napster. But does that justify the stock's surge?

"I'm concerned about Roxio's cash burn and that larger players are more well-financed. It becomes a question of can you afford the marketing expenses to compete," said Rowen.

Roxio will change its corporate name to Napster following the sale of the software division. So it appears that some investors must be hoping that Wall Street will be willing to value a pure play online music company at a premium to a software company.

Stock doesn't deserve a premium

P.J. McNealy, an analyst with American Technology Research, thinks that would be a mistake.

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"There are concerns about Napster's business model and profitability and just because Napster is a standalone entity doesn't mean that the challenges go away," he said.

Along those lines, McNealy said that it will take some time for Roxio to convince music buyers to abandon the pay per download model that Apple has popularized with iTunes in favor of its subscription service model.

"Consumers are more familiar with the a la carte model of paying 99 cents or so for a song than paying $15 to $20 a month for a service. It takes time to change behavior," said McNealy.

Finally, the stock now looks pretty expensive on a price-to-sales basis as a standalone company. Rowen estimates that the Napster business will generate about $36 million in sales in fiscal 2005 and $60 million in fiscal 2006.

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By Paul R. La Monica

Using the latter estimate, and Roxio's market value of about $225 million, Roxio trades at about 3.8 times next year's sales estimates. Apple (Research), by way of comparison, has a price/sales ratio of 1.8 and RealNetworks' (Research) is 2.6.

So investors looking for a way to cash in on the digital music craze might want to find another song to sing. Until Roxio can prove that it can make money from Napster, the stock deserves to trade at a discount, not a premium, to its larger online music challengers.

Analysts quoted in this story do not own shares of Roxio and their firms have no banking ties to the company.


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