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The Sweet Sounds from Audible

By Scott Kessler Audible (ADBL) is the world's leading provider of digitally delivered spoken-word audio content. In our opinion at Standard & Poor's, it has been benefiting from the widespread and growing deployment of portable audio devices and associated strong demand for digital audio content. Its stock carries Standard & Poor's highest investment recommendation of 5 STARS, or strong buy.

The Wayne (N.J.)-based company allows consumers to purchase and download spoken audio content to their computers and portable audio devices. It offers access to more than 70,000 hours of media and 28,000 titles, many of which cannot be obtained elsewhere. Such content includes audio versions of books, newspapers, magazines, and original productions.

It offers this content via subscriptions and downloads. Consumers shop for, purchase, and download spoken-word media, generally directly from Audible's Web site or from Apple Computer's (AAPL) iTunes Music Store. Audible is the exclusive provider of spoken-word content via iTunes.

BEYOND AUDIO BOOKS. AudibleListener is the company's monthly subscription service for $14.95 to download any one book and one subscription offering (BasicListener) and $21.95 to download two audiobooks (PremiumListener). Customers can also purchase individual titles, and subscribe to one of Audible's dozens of daily, weekly, or monthly offerings. Using the company's Web site, a new customer who commits to 12 months of the AudibleListener service can receive a free or discounted audio player, which is provided as an incentive to join the program.

Audible's goal is to bolster its position as the leading provider of subscription-based, digitally delivered, premium-quality spoken-word audio content. Its strategy is to increase brand awareness, expand its collection of content, produce greater distribution, expand internationally, and pursue new initiatives.

In December, 2004, the Audio Publishers Assn. estimated the size of the audio-book market at $800 million. Based on Audible's 2004 net revenues of $34.4 million, it had captured a mere 1.3% of this segment. However, we think Audible's market opportunity is considerably larger than just audio books.

STRATEGIC PARTNERSHIPS. According to IDC, worldwide shipments of portable audio players are expected to more than triple, from 32.8 million in 2003 to 116.1 million in 2008. In our opinion, this significant user base and projected growth offer substantial opportunity for Audible, given that 56.1 million audio devices were shipped last year, and the company had only 467,000 customers from 1997 through 2004. More than 135 kinds of devices are compatible with Audible's technology.

Moreover, it has also been readying Audible Wireless, which will enable its content to be downloaded and accessed via wireless phones. It's intended to better pursue what we regard as the vast wireless-handset opportunity. Forthcoming functionality is expected to enable automated downloads of preselected content. Audible's initial noteworthy foray in this segment was its technology and marketing deal with Sprint (FON) in September, 2004.

And earlier in June, Audible announced an exclusive partnership with XM Satellite Radio (XMSR), which we believe eventually will enable it to pursue what we consider to be the very lucrative automotive audio market.

USER EASE. Given the notable current and anticipated deployments of Audible-compatible devices as well as substantial access to, and demand for, digital content, Audible sees its market opportunity as consisting of everything from audio books to talk radio, business information, publishing, magazines and newspapers, and education and related materials. These constitute a market opportunity of more than $100 billion.

In addition, over the past year, Audible has launched offerings in France, Germany, and Britain.

Several competitive factors will enable Audible to maintain and increase its share of the spoken-word audio market, we believe. For one, the company possesses significant technology advantages, in our view. Audible has been providing and improving its spoken-word audio offerings since 1997. It pioneered the segment and delivers appealing user functionality, much of which is supported by proprietary intellectual property.

PATENT POWER. For example, Audible's patents enable customers to skip between selections, individual articles, and chapters within selections. Customers can also pause and resume listening where they left off, and can "bookmark" multiple sections of content, rather than be constrained by the rewind and fast-forward functions.

Audible also offers, in our view, proven and patented digital-rights management that enables publishers to control and monetize their content.

Our research indicates Audible has 10 patents related to digital audio. Interestingly, we believe it holds more patents than online stalwarts Amazon (AMZN) or eBay (EBAY), and it has nearly as many as technology powerhouse Google (GOOG).

FORAY INTO SCHOOLS. Audible offers tens of thousands of titles from more than 224 partners (as of the first quarter), some 60% of which are exclusive relationships. In the second quarter, it announced content partnerships with Harlequin and Pearson Education, in addition to XM Satellite Radio. We expect Audible to increasingly prioritize exclusive content. Moreover, owing to its publishing heritage and expertise, we think Audible will start to play a greater role in developing original content such as author interviews.

Audible's agreement with Pearson is part of the forthcoming Audible Education initiative, which we expect to be launched during the back-to-school season. We think the program's initial focus will be higher education (the college market), life learning (including self-help, language, and business content), and test preparation (for admissions and licensing exams). Audio versions of Pearson's higher-education study guides are scheduled to be available for the 2005-06 academic year, and the companies expect to create and market education audio offerings for the general consumer later this year.

Distribution is key to Audible's competitive position, in our view. Besides its exclusive-provider arrangement via Apple's iTunes, Audible also has a distribution relationship with Amazon (which we believe could be revisited subject to Amazon's indicated interest in pursuing the digital audio-books market on its own). Best Buy (BBY) and Circuit City (CC)are traditional retail-distribution partners.

JUMP ON COMPETITORS. Expanding its distribution relationships is a priority for Audible, in our view. Logical potential partners include Barnes & Noble (BKS) and Wal-Mart (WMT), as well as Internet giants America Online (TWX), Google, MSN (MSFT), and Yahoo.

Audible is compatible with more than a hundred wireless devices, including Palm One's Treo 650 and Apple's iPods. The iPod holds nearly 80% share of the market for digital-audio players with internal hard disk drives.

Beyond this compatibility is Audible's singular focus on spoken-word audio content. A number of companies could enter the segment, but none, in our opinion, have the significant experience and expertise, proprietary technology, breadth of content, distribution relationships, and expansive compatibility of Audible.

STRONG HIRES. Regarding corporate governance, Audible's board has a majority of outsiders. The insiders include Chairman and CEO Donald Katz and Chief Financial Officer Andrew Kaplan. Katz co-founded Audible nearly 10 years ago, in November, 1995, after being an author, business journalist, and media consultant for over 15 years.

Kaplan assumed the positions of CFO and vice-president for finance and administration when he joined the company in June, 1999. The balance of the nine-member board consists of several executives with substantial expertise in the areas of media, book publishing, technology, and finance, with representation from Bertelsmann, News Corp. (NWS), and Random House.

We believe Audible's corporate-governance practices are adequate, given its relatively small size and recent rapid growth. We expect Audible to endeavor to improve its practices and see as constructive actions the recent hires of Glen Rogers (previously vice-president for information technology at Public Service Enterprise Group (PEG), New Jersey's largest utility) as chief operating officer and David Joseph (previously director of investor relations at eBay) as vice-president for communications and strategy. Many of Audible's corporate-governance shortcomings, in our view, could be corrected with relatively simple actions, such as additional disclosures, which we foresee occurring sooner rather than later.

EARNINGS DAYLIGHT. We project that Audible's net revenues will increase 90% in 2005, to $65.3 million, and 77% in 2006, to $115.9 million, driven by growth in both AudibleListener members and their activity, and in a la carte downloads from and iTunes (which accounted for some 14% of Audible's net revenues in the first quarter of 2005). We believe revenue increases will reflect the expansion of content and distribution relationships, enhanced marketing, and new initiatives (such as Audible U.K., Audible Wireless, and Audible Education, which we foresee having a material impact in 2006).

Investments in new programs and to bolster customer service will have a negative impact on margins in 2005, in our view. However, Audible will start benefiting from economies of scale relative to certain operating functions. We also look for customer-acquisition costs to continue trending lower from the first quarter's $40 level, owing to greater efficiency in marketing and promotions. Thus, we're modeling that Audible's annual operating margin will narrow somewhat in 2005 and widen substantially in 2006.

Reflecting the factors described earlier and our higher projected yearly tax rate in 2005 (owing to Audible's profitability in 2004), we expect operating earnings per share to remain flat year over year. However, we project EPS to climb from 10 cents in 2005 to 47 cents in 2006.

RICH VALUATION. We project a 2005 Standard & Poor's Core Earnings estimate of 2 cents, 8 cents lower than our forecast operating EPS estimate. The difference reflects anticipated stock option expense of $2.2 million. We forecast 2006 Standard & Poor's Core EPS of 41 cents, some 13% below our operating estimate, again owing to projected expenses related to stock options (of $1.8 million).

Audible's stock-option expense will decline annually each year from 2003 to 2006, in our view. We believe this reflects its relative conservatism regarding stock-option grants and the greater use of restricted stock for compensation. Audible doesn't have a defined-benefit pension plan. Based on our Core EPS analysis, we believe that it has average to above-average earnings quality compared with its peers.

Based on our 2005 forecasts, Audible appears richly valued. The stock trades at 179 times our 2005 EPS forecast of 10 cents. Notwithstanding our forecast for average annual EPS growth of 40% over the next five years, the shares still have a p-e-to-growth (PEG) ratio of 4.5. Audible's 2005 p-e multiple and PEG ratio are considerably in excess of the S&P 1500-stock index and company peers.

HEALTHY CASH FLOW. The stock seems more appropriately priced in light of our 2006 projections. Audible has a 2006 p-e of 38, based upon our EPS estimate of 47 cents. The shares have a 2006 PEG of 1. These metrics are comparable or lower than those of many other Internet stocks.

However, for several years, the foundation for most of our valuation work on Internet stocks has been predicated on our discounted cash-flow analysis. In 2004, Audible became free cash-flow positive for the first time. We expect it to generate $1.9 million in free cash in 2005, reflecting notable investments in geographic expansion, new initiatives, and customer service.

In our opinion, these and other investments will pay off in the coming years. As such, we project that free cash will surge to $51.2 million in 2009. Employing a discount rate of 14.9%, reflecting Audible's high beta of 1.98 and a perpetuity growth rate assumption of 3%, yields an intrinsic value calculation of about $26. Owing to some of the risks described below, our 12-month target price is $25.

HUMMING ALONG. Risks to our opinion and target price, in our view, include a change in Audible's productive relationship with Apple and its iTunes Music Store, greater competition than we anticipate in the spoken-word audio-distribution market, more appreciable churn rates than we foresee, higher costs than we forecast for content and customer acquisition, and less success than we foresee with international expansion efforts and new initiatives.

We believe Audible is well-positioned to capitalize on a substantial market opportunity and has notable and durable competitive advantages, a positive financial outlook, improving corporate-governance practices, favorable relative earnings quality, and an attractive valuation. Kessler follows Internet software & services and Internet retail stocks for Standard & Poor's Equity Research

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