Thursday, July 13, 2006

Interesting Call of The Day - Napster (NAPS) from Craig-Hallum

George Sutton from Craig-Hallum Capital saying an ever-expanding list of legitimate competitors entering and/or seriously considering entry into the online music market, they are becoming convinced that Napster (NASDAQ:NAPS)'s independence could be short-lived.

After new or expanded offerings from Viacom-backed Urge, Yahoo, Rhapsody and well-documented offerings being considered by Microsoft, Amazon and Google, the firm thinks Napster's heretofore advantages - brand-name, subscription-platform and user functionality - will become increasingly less relevant and more commoditized.

The company is in the early stages of a new advertising-led strategy with its "free" site. Unfortunately, the initial impact of the free offer will be a slowdown in net new subscriptions, in a seasonally slow subscription-add period (Q2 and Q3). With a need to grow its subscription base nearly four-fold to achieve profitability, slowing adds for any reason will likely force the company's hand.

With $2.38 per share in cash, more than 500K subscribers, a valuable subscription platform and a well-known brand name, they believe the stock is worth well more than its current enterprise value of $30 million. As with any undervalued stock, one has to ask "how will the value be recognized?"

Enter the shareholder activist, ever more common in this very difficult market environment. We would suggest that insider ownership of less than 6% (based on the most recent 2005 proxy statement) presents little resistance. Management has consistently suggested that it has been approached by "many interested parties," some of which the firm would guess and some of which they wouldn't. If this is the case, an activist could help force such discussions to the surface and help recognize the value disparity that exists.

To help quantify our point, an article in the NY Post suggesting that Google and Napster might be in talks pushed the stock up approximately 50% over a one month period (the stock has since more than retraced the move). With its cash position, this stock is poised to see substantial value spikes on incremental news.

Fundamentally, while they expect a couple of weak net new subscriber quarters, they do believe the company will participate as the market moves online (away from store-based CD sales) and feel that better Napster-compatible MP3 product will be available in the Fall, helping correct a major deterrent to growth.

Maintains Buy and $7 tgt.


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