Archive for April, 2011
Many rumors swirling yesterday about Kazaa/ATRN getting acquired or getting some investment from Facebook. While we have no first hand knowledge of such a deal, we believe that such a deal might not be as far fetched as some of the short sellers of ATRN and other negative posters to the many online investment forums would have everyone believe.
Sean Parker, one of the largest holders of Facebook stock who is famous for his role in developing Kazaa forerunner Napster and more recently for his role in the startup of Facebook (depicted by Justin Timberlake in “The Social Network”), invested approximately $15 million in an on demand streaming music company called Spotify in February of last year. Spotify is very similar to Kazaa in that is offers an on demand streaming music service but is much larger in terms of subscribers and that it is licensed only in Europe. One of the things that has distinguished Spotify from its competitors (Kazaa, Rhapsody, MOG, Rdio) has been its use of the “Freemium” model to build its user base. This approach allowed users to get access to on demand streaming music for free with some access limitations and the company monetizes the service through advertising and attempts to upsell the free users to its paid subscription service.
This approach has allowed Spotify to build one of the largest subscriber bases in the industry, but it apparently has not earned it a free pass with the music labels who are leery of the services that do not convert enough of the free users to paid users. Many industry pundits have suggested that this is the reason that the labels have not granted Spotify a US license yet. Just last week, Spotify significantly scaled back the amount of free music that its non paying users could access, which has caused an uproar and increased attrition among its user base. This has to cause some concern among investors in Spotify, who no doubt had assumed that it would be able to use the unrestricted freemium model worldwide.
Not long after Spotify added features integrating its users with their Facebook accounts, Parker invested a little over $15m dollars to buy a 5% stake in Spotify. He said at the time that Spotify was seeking US licenses from the four major labels and that they should be live in the US by the end of the year. Fast forward 14 months and Spotify is still trying to get US licenses from the four major labels. Kazaa (as of Monday morning) is now owned by a company (ATRN) whose entire market cap was just over $15 million and they (Kazaa) already own licenses with the four major record labels. Kazaa’s founders paid over $100 million for the licenses back in ’07. Kazaa built tools integrating its service with Facebook a couple of months ago, is it possible that Mr. Parker or his companions at Facebook are seeing the latent value in Kazaa? If Mr. Parker paid over $15 million to get 5% of a company (Spotify) that has been unable to enter the most lucrative market for music consumption (US), what might he pay to take a 5% or larger stake in a company that already has those licenses and their $100m+ cost fully paid for? On the other hand, maybe the run up in ATRN/Kazaa yesterday is simply investor realization of the value of what Kazaa owns.
We have received quite a bit of correspondence from Groove members since the release of ATRN’s Q4 numbers and this has grown substantially following the conference call. I think it would be fair to say that the majority of ATRN shareholders represented here were very disappointed that we did not get more transparency with regard to non financial metrics through the end of Q1. The combination of the late filing, lack of notice prior to the late filing and the unwillingness of management to discuss Q1 metrics has lead many to trim their holdings, with many removing all but the number of shares that represent the dollar value of their gains. We continue to believe that ATRN shares do not come close to reflecting the potential value of Kazaa, but understand that the happenings of the past couple of weeks have caused many to give increasing weight to the execution risk side of the risk/reward measure.
A quick review of the things we learned from the Q4 release/conference call about each division –
Atrinsic Interactive – Management did not indicate that this business was growing again, instead suggesting that revenues for Q1 would be more likely to be in line to marginally higher, specifically objecting to use of the word “trough” to describe the Q4 results. This changes our valuation of that division as we would have expected it to command a market valuation similar to others that have sold over the last couple of years, but the nature of the situation with ATRN’s financial position and the declining revenue base with AI leads us to believe it may be worth $5 million or less vs. the $10m+ potential we previously believed based on an expected turnaround in that division suggested in an early Q4 conference with AI management. Comparable deal valuations still point much higher than that, but the totality of the circumstances here begs for the lower valuation until we hear from management that this segment is growing again.
Kazaa/Subscription – The growth in Kazaa subs was substantial and very important to put into context, as this growth was achieved in the middle of a major restructuring effort that management concedes has required them to be “very tight” with working capital. It also occurred prior to the roll out of mobile access and many of the other value adding features the company introduced towards the end of Q1. Even more important, they did this while not making a substantial increase in their marketing spend, as COO Mr. Musci described the increase as driven almost equally by lower attrition rates, increased organic (word of mouth/GrooveVC style marketing) sign ups and lower SAC in addition to a small increase in marketing spend. Further, ATRN management did indicate that subscription revenue “picked up significantly” in the last month of the quarter. Unfortunately, any potential for a positive marketplace reaction to this aspect of the Q4 numbers was likely muted by management’s unwillingness to update the subscriber counts through the end of Q1.
In summary, we may have to make a downward adjustment of our valuation for ATRN’s non Kazaa assets, but we still believe Kazaa alone is worth substantially more than the current ATRN market cap. ATRN management’s discussion of the Q4 results leads us to believe that they may not deliver blow out numbers for Q1, but all indications suggest that March was a very strong month for Kazaa and we should start to see this momentum manifested in the Q2 numbers.
A quick update on ATRN’s Q4 numbers as reported Thursday night
1) The Good – Kazaa subscriber counts increased dramatically during a time when the company’s stated intention was to slow marketing expenditures to focus on a large restructuring effort. We had expected to see subscriber numbers flat to slightly higher given management’s focus on the consolidation of the far flung Kazaa operations and continued build out of the Kazaa service. The near 20% Q over Q growth in Kazaa subscribers was much larger than we had hoped for and suggests to us that Kazaa is thriving despite difficulties within other segments of Atrinsic. Of course, we have a pretty good idea where several thousand of those new subscribers came from, as our late September intro of ATRN as a focus stock means that most Groove subscribers are probably included in the Q4 count, though I would be surprised if our subs equaled even half of that gain. The good news for ATRN management and shareholders is that those subscribers should not attrit any time soon and they will start to impact the overall company LTV metric in a positive way now that we have been here for six months now. Kazaa is the reason we are holders of the stock and we hope to see if Kazaa’s subscriber acquisition momentum has carried over in Q1 ’11.
2) The Bad – the Atrinsic Interactive segment’s revenue decline was a disappointment. Our takeaway from multiple conference calls over the last four months was that this segment had turned a corner during Q4 and that we would see revenue start to level off. Even if this turn is just pushed forward a month or so, we still find the size of the revenue decline in Q4 to be a negative surprise. Absent a significant rebound in Q1, we would need to adjust our potential sale valuation unless Thursday’s conference call makes it clear that this business is growing again vs. contracting further.
Also, while the cash balance at year end was higher than we expected, working capital was slightly lower than we expected and we were disappointed that the cash burn rate was not reduced more significantly.
3) The Ugly – waiting until the 11th hour (literally) on the SEC filing deadline day to file, with no previous indication that the results could be delayed and scheduling the conference call to discuss the results a full week later. The market hates uncertainty and this approach breeds uncertainty, particularly when aspects of the numbers that are reported are less than stellar. This is ugly and at this point appears to fully validate the issues we addressed with #’s 2 and 3 on our “BOD Wish List” last month. The saving grace would be if the reason for the delay in the conference call were to incorporate a positive development that could not be finalized by April 1. In the absence of such positive company developments discussed on Thursday and/or some other compelling reason for the delayed filings and conference call, the net result could be a significant loss of management credibility with shareholders to a degree that only extreme fundamental changes in management’s investor relations approach or changes in management personnel could address.
One positive recent development has been the continued and growing interest in ATRN by short sellers. The impact of the message board shenanigans that might cause some traders and less experienced investors to sell their shares is a small price to pay to have the increased liquidity and frenzied buying on each positive development that accompanies their presence, not to mention the comfort to longs of knowing that there is such a large number of shares that will be purchased (covered) in the future. We hope that the sell off related to the negative financial aspects of last week’s release allows them to regain some confidence in their endeavor.
At the end of the day, the upside in ATRN is, was and will be all about Kazaa. The Q4 numbers posted last week were not nearly as disappointing to us as the manner in which they were presented. though we are withholding our judgment on the management team at ATRN until Thursday’s conference call. On Thursday we expect to learn why management chose the unorthodox approach of reporting at the last minute and scheduling a conference call a full week later in addition to the story behind the numbers and an update on Q1. Additionally,we have been expecting ATRN to raise additional capital to enable a bigger marketing push for the Kazaa service, be it through the sale of non strategic assets, an IPO of some portion of the Kazaa business or some other method and we hope to learn more about the direction management is leaning in that regard.