Two Pullbacks Sing Opportunity

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News that Yahoo! (YHOO Quote) is rolling out its own monthly online music service at a significantly lower price than the competition sent shares of RealNetworks (RNWK Quote) and Napster (NAPS Quote) plunging this morning to $5.80 and $4.27, respectively.

We believe investors who want a short-term trade should consider taking a long position in these two stocks. (We aren't taking any action because we are fully invested.)

We view the respective 20% and 30% selloffs Wednesday morning in RealNetworks and Napster as overdone and believe Napster's earnings report after the close will drive shares of both companies 10% higher by the end of the week. Analysts expect the company to lose 62 cents a share on sales of $17 million.

We expect Napster to surpass these analyst expectations in its earnings report, similar to the performance that competitor RealNetworks delivered last week. For the first quarter, RealNetworks had sales of $76.6 million, up 27% year over year, and above consensus revenue estimates of $75 million. Break-even earnings came in ahead of analyst expectations for a penny-a-share loss.

RealNetworks also raised revenue guidance by $10 million to a range of $320 million to $330 million, and raised EBITDA guidance by $3 million to a range of $25 million to $28 million. Today's announcement of RealNetworks' acquisition of mobile games designer Mr.Goodliving.com adds another $3 million in sales for 2005 that is not in its previously issued guidance.

Also, Yahoo!'s music page reveals that its format for digital music is not compatible with Apple's (AAPL Quote) iPod. While this will likely change in the near term, it has not been widely reported in the press and will likely cause investors to reconsider their near-term opinions of RealNetworks and Napster.

Both companies are sitting on healthy cash balances that limit near-term downside potential. RealNetworks has $2.16 a share in cash and some long-term investments on the balance sheet, while Napster has about $3 a share in net cash. Also, 17% of Napster shares and 6.5% of RealNetworks' shares are sold short, so any good news in Napster's earnings tonight could lead to a nice move higher tomorrow.

In the long run, we remain bearish on this group, primarily because of the stiff competition within it. Yahoo! will price its monthly downloadable music service at $6.99 a month, and we believe this will lead to margin compression in the long term. And Apple will likely come to market with a subscription-based product at some point, putting further pressure on margins of the smaller competitors. As such, we would put 10% stops on these two trades, and close them out by Friday.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Napster to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.