RealNetworks: Time to Sell Rhapsody?
Six months earlier, on Mar. 9, the company had tumbled to an all-time low of 2, leaving its market value below its cash—a sign of a company that's either undervalued or headed for trouble. RealNetworks' stock has rebounded since then, closing at 3.80 on Sept. 28, but the company still faces a raft of challenges, many related to its subscription music business, Rhapsody. To keep the stock headed in the right direction, RealNetworks executives may want to consider exiting the consumer music business altogether.
Expenses at the music business are outpacing top-line growth just as an already crowded streaming music field may need to accommodate another player—the formidable Apple (AAPL). RealNetworks has other businesses to fall back on. Its largest, the products and services group, helps text and multimedia messages cross competing wireless phone networks and could be augmented through acquisitions. RealNetworks also has a casual gaming business.
One of the toughest obstacles for the Rhapsody music business is the pace of expense growth. In its most recent quarter, music sales rose 9% to $40.4 million, or 30% of the company's total revenues. Expenses rose more than twice as much, increasing 21% to $25 million, accounting for 62% of the total. As Rhapsody attracts more subscribers—the tally rose 150,000 from a year earlier—it has to pay more in royalties to record labels. "The ideal Rhapsody subscriber is one who doesn't use the service much because the more you use it, the more it costs RealNetworks in royalties," says Pacific Crest Securities analyst Andy Hargreaves. "I don't understand how the math changes for the better with more subscribers."
Pandora Is Free While Apple Lurks Worse, subscriber revenue has recently shifted to lower-margin services, RealNetworks said in an Aug. 7 filing with the Securities & Exchange Commission. RealNetworks Chief Financial Officer Mike Eggers says that over time, subscriber increases do not result in "significant" increases in royalty fees and that eventually, the subscriber base will be large enough to reach breakeven. Currently Rhapsody has 750,000 subscribers who pay between $12.99 and $14.99 a month for on-demand music. The site also has dozens of free streaming music stations.
Expenses aside, it's getting harder to stand out in a business where online music streaming is becoming increasingly cheap and easy to find. Take Pandora, which lets users set up their own radio stations based on their musical tastes. It also offers music subscriptions, but most of Pandora's 30 million users listen to the ad-based service at no charge.
Rhapsody's plight would become infinitely more challenging in the event that Apple, as rumored, were to set up its own music subscription service. "Apple could turn that service on in a day," Hargreaves says. "The competitive environment would get difficult real quick." An Apple representative declined to comment.
Rhapsody, which is minority owned by Viacom's (VIAB) MTV Networks, has some advantages, including a relationship launched in mid-2008 with Verizon Wireless, itself owned by Verizon Communications (VZ) and Vodafone (VOD). Verizon customers accounted for much of the company's recent revenue growth, although RealNetworks recently got a green light to make its service available to users of the iPhone. Rhapsody applications already run on other wireless devices, including Research In Motion's (RIMM) BlackBerry.
Still, Rhapsody is at best a cash-flow-neutral business, says Tavis McCourt, an analyst at Morgan Keegan. The service's appeal, especially at $15 a month, is limited, analysts say. RealNetworks declined to comment on the prospect of exiting Rhapsody.
Wireless Data Acquisitions? So without music, what is RealNetworks? For starters, it's a decent software company focused on casual gaming. In 2008 the games unit showed so much potential—in the first half of the year it reported only a $4 million loss on revenues of $67 million—that Real sought to spin it off. Volume has since grown by 12%. And while it's true that revenue has dropped and losses have widened, some analysts see greater potential in casual gaming than streaming music.
The greatest potential may lie in the technology products and solutions group, which counts Korea's SK Telecom among its larger customers. Revenue has suffered in that division, too, but RealNetworks could shore it up through acquisitions of small, private wireless-data companies. One potential target is Motricity, which is backed by Intel (INTC), among other investors. "This is a fast-consolidating industry with lots of small, private players," McCourt says.
Selling off music wouldn't solve all the woes RealNetworks faces. The company is in the midst of a legal battle with Hollywood movie studios that object to its RealDVD software, which would let consumers copy DVD movies to their hard drives. RealNetworks lost the first round of the case in July but is still fighting the case. Even in the unlikely event that it wins, other companies might easily replicate the technology in question.
A second legal threat is more serious. In July, RealNetworks lost an arbitration with VeriSign (VRSN) over a partnership dating to 2001. VeriSign alleged that Real had prevented it from selling off some business units. RealNetworks said in a July regulatory filing that VeriSign is seeking "material damages."
Should VeriSign prevail, RealNetworks may end up in a better position to pay those damages—and meet its manifold other challenges—if it leaves Rhapsody behind.