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A Real Threat to Microsoft?

By Amey Stone Sometimes being the underdog isn't so bad. Take RealNetworks (RNWK), which is locked in a fierce battle with Microsoft (MSFT) to dominate the market for audio- and video-streaming software. RealNetworks recently signed deals with some powerful Microsoft competitors that have caught the attention of analysts and could reap handsome returns if the economy start to improve.

What's to like? Consumer-electronics maker Sony recently agreed to add Real software to its PlayStation II system, which competes with Microsoft's new Xbox video-game console. Hewlett Packard, too, will build Real into its new digital-entertainment devices.

The deals don't end there. On June 20, Real announced a new digital-rights management package to be created with such partners as Sun Microsystems, Adobe, and IBM -- all companies eager to put the Microsoft juggernaut in dry dock. Real also has new agreements with Nokia to add streaming software to mobile-phone handsets and with Cisco to build streaming capability into its Internet routers. "Cisco's routers make up 80% of the whole Internet," says Phil Benyola, a digital-media research associate at Raymond James. "When you have Real software included in every router, it really starts to become a standard."

"VALUABLE THORN." Perhaps most important, RealNetworks has media behemoth AOL Time Warner in its corner. Real's streaming software became a key point of contention between AOL and Microsoft. The Colossus of Redmond wanted its own player incorporated into America Online's Internet service. AOL insisted on sticking with Real. The upshot: "For AOL, RealNetworks is a valuable thorn in the side of Microsoft," says CIBC World Markets analyst John Corcoran.

To hear both Real and Microsoft tell it, all this maneuvering is strictly business. "Certainly, some people are going to competitively align against us, and that is to RealNetwork's benefit, I suppose," says Will Poole, vice-president of the Windows digital-media division at Microsoft. Poole points out that Microsoft has plenty of technology partners, too, and no shortage of distribution of its streaming software.

Real attributes all of its recent deals to the strength of its technology. "We all agree that having a choice in this space is a good thing," says Steve Banfield, who heads Real's consumer products division. He says Real's focus isn't on Microsoft, which bundles its Windows Media Player with its operating system. "I have 200 million customers to keep happy," he says, referring to the number of personal-computer users worldwide who have downloaded the RealPlayer.

SELLING CONTENT. Some analysts like what they see. True, gone are the days when strong partnerships were enough to spur an Internet stock. And in this year's difficult environment for software sales, Real's stock has remained stuck between $5 and $10 after tumbling during the dot-com meltdown from its split-adjusted peak of $91 in January, 2000.

Investment firms Raymond James and Thomas Weisel Partners both upgraded Real's stock in May, citing the revenue potential for two of its newer businesses. In less than a year Real has signed up an impressive 200,000 customers to its $9.95 a month GoldPass service, which allows customers to watch sports programs and other broadcast content on their PCs.

"We've proven that people will pay for content on the Web," says Banfield, who says Real will broaden the service. Observes Corcoran: "If they get up to a million subscribers, it will start to be a real business for them."

Then there's MusicNet, a separate company that provides a technology platform from which other companies can sell music over the Net. Real owns 40% of MusicNet, and it provides an even "brighter spot," according to Corcoran. The official launch of MusicNet, expected this fall, could be an additional catalyst for the stock to rise, says Rob Martin, an analyst with Friedman, Billings, Ramsey.

SLOW PICKUP. Real's biggest challenge now is to get revenues headed upward once again. From a peak of $67 million in the third quarter of 2000, revenues came in at $50.4 million in the first quarter, reported Apr. 17. Real gets most of its sales from companies that use its software to deliver streaming audio and video. Doug van Dorsten of Thomas Weisel predicts revenues will start slowly accelerating next quarter but still come in at $229 million for 2001, down from $242 million for all of 2000. "I'd really like to see a recovery in the software sector before we go to a strong buy on the stock," says Benyola, whose firm upgraded the stock to buy in May.

While the company is profitable on an operating basis -- the most recent quarter was its seventh consecutive one in the black -- earnings are slumping. Van Dorsten projects it will earn $0.09 a share this year, down from $0.18 last year. In 2002, he looks for $0.14 on revenues of $317 million.

Meantime, RealNetworks is still swimming in dangerous waters. Microsoft is making the delivery of high-quality audio and video a key feature of its Windows XP operating system, coming this fall. Martin believes Real will have to maintain a strong lead over Microsoft technically -- which some analysts think it has already lost -- in order to keep its customers.

POTENTIAL RIVAL? "People like an alternative to Microsoft, but at the end of the day you still have to have a better product," he says. According to Corcoran, there's still the risk that AOL and Microsoft will strike a deal down the road. "Will they come back to the table at some point in the future? Probably yes. Tomorrow? Probably not," he says.

Microsoft's Poole points out that by getting into the content-delivery business through GoldPass, Real is potentially competing with many of its customers, including AOL. "They've done well with that first 200,000 subscribers," he says. "You have to wonder which giants are going to wake up and start worrying about them."

For now, investors in Real can take heart that it has strong partners, a new source for recurring revenues in GoldPass, and is a key part of MusicNet. With its revenues and earnings slumping, those positives may not add up to a good reason to buy the stock. Unless, that is, you see value in pushing on one of the sharpest thorns in Microsoft's side. Stone is an associate editor of BusinessWeek Online and covers the markets in our daily Street Wise column.

Questions or comments? Join in the discussion at our Ask Amey Stone interactive forum

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