The noise that surrounded
launch of MSN Music last week underscores the opportunities many investors see in the online music market now dominated by
But scouting out the next big hit to take advantage of the growing popularity of music downloads and Apple's iPod, the top-selling portable media player, is no easy task for investors. Microsoft, for instance, has acknowledged that the launch of its music store last Thursday is unlikely to have any measurable impact on its financials. And investors may be loath to buy Apple shares, given the stock's recent run --
a whopping 66% climb since the beginning of the year.
Besides the other most well-known investment choice,
, only a couple of pure plays --
-- are taking advantage of this online music trend, investors and analysts say. And their story is a tale of two very different investments.
"One is a differentiated product, a subscription-based model
Audible that has scale ... and is not facing a lot of intense competition," said Steven Frankel, an analyst with Adams Harkness, who has a buy rating on Audible and a reduce rating on Roxio. "The other is facing intense competition in a business where you have to spend a ton of money to get the consumers.
"One company is generating cash and profitable, and another is unprofitable," Frankel added. (His firm hasn't done investment banking with either company.)
Wayne, N.J.-based Audible allows users to download audio content from a range of sources -- including the
The Wall Street Journal
, National Public Radio and Random House, which is a large Audible shareholder -- onto their PCs, iPods and other media players. Both a subscription and an a la carte service are available through Audible's Web site, and the company also supplies content to
and Apple's iTunes music store.
Audible investors like the company's impressive earnings and revenue growth trajectory, which was driven in part by expansion in international and education markets. Just this week, Audible, which charges $14.95 or $21.95 a month for a subscription, announced plans to launch a similar service through a joint venture in Germany.
Another potential plus: Rumors have swirled about Audible being eyed as an acquisition target by Amazon and the online movie rental service
. Audible stock closed Friday at $12.07, up about three times from where it was a year ago.
"It's very much a software model," says Fil Zucchi, founder and managing member of Zebra Fund in McLean, Va., and a contributor to
. "Once you've got the product done and got distribution out there, every additional dollar that comes in carries higher and higher margins."
Audible does not release total subscriber figures, but analyst estimates range from 114,000 to 130,000. The company added 24,500 new subscribers and a total of 35,250 new customers last quarter, which ended June 30.
Analysts are expecting Audible's pro forma earnings to more than quadruple in one year -- from 7 cents a share in 2004 to 33 cents a share in 2005, according to Thomson First Call. Revenue, some of which is recognized over the life of a subscription, is expected to climb 43% to $47 million in 2005.
However, the company's last quarter, while strong, was marred by higher costs of increasing subscriptions and a drop in margins. The company's acquisition cost per customer jumped to $40 from $31 sequentially, largely because of more subscribers taking advantage of a $100 rebate on media players. As a result, content gross margins fell sequentially to 64% from 69%.
"That's the only thing you could harp on," Zucchi said. "Some people I guess are a little bit afraid
Audible might fall into the Netflix issue where it costs you more and more to acquire customers."
The difference is that unlike Netflix, Audible has no direct rivals, Zucchi said. Audible's only competition these days comes from tapes and CDs, because no one else offers such broad audio content for download from the Internet.
By contrast, Roxio just recently became a player in the extremely crowded online music field. Besides Microsoft,
MTV Networks and
are expected to follow in coming months, joining earlier entrants RealNetworks, Musicmatch,
and Tower Records.
"It is precisely the type of company I think that has a problem," Zucchi said of Roxio. "It's everybody and their mother in that space, and working with margins that basically don't exist as it is. That, to me, is a nonstarter."
Santa Clara, Calif.-based Roxio
sold off its software division last month to focus exclusively on online music by relaunching a pay version of Napster last October, after buying the brand in a bankruptcy auction.
But Frankel believes the well-known Napster brand has failed to live up to expectations. "They've been very slow to ramp the business," he said. "Napster is so 1999."
In its latest quarter, Napster added 30,000 subscribers to reach more than 130,000. Although this is comparable to Audible's subscriber base, Frankel called it "a long way from a predictable, profitable subscription model." Rival RealNetworks has 550,000 subscribers and is adding about 100,000 a quarter, he noted.
Frankel forecasts Napster sales of $30 million to $40 million in fiscal 2005, but he lowered his rating to reduce from market perform on May 22, 2003. Since then, Roxio's stock price has fallen by about 50%. Roxio shares closed Friday down 9 cents, or 2.5%, to $3.48.
"All bets rest squarely on Napster, and the business is not yet scaling rapidly enough for us to raise our rating," Frankel wrote after the company's first-quarter earnings report last month.
But Steven Cutcliffe, a managing director with CSI Capital Management in San Francisco who holds Roxio shares, believes Napster will benefit from Microsoft's pushing its Windows-based media software as the behemoth takes on Apple.
In addition to its MSN Music launch, Microsoft introduced two other products that could help widen Napster's audience: portable media center players based on Microsoft software and digital-rights management software, which enables subscribers to download music to portable players; before, subscribers could only listen on their PCs.
Napster became the first company to take advantage of Microsoft's new software with the debut last week of a new subscription service. RealNetworks is the only other company that sells music by subscription -- a smaller market than a la carte downloads -- and RealNetworks' service doesn't yet offer the ability to play music on portable players over the lifetime of a subscription.
Although Napster stands to gain as Microsoft pushes its new technology, Cutcliffe acknowledged that he was "a little disappointed" about Roxio's software division divestiture. The division posted a $6 million profit on $22 million in revenue last quarter, accounting for almost three-quarters of total sales.
"That was always my fallback," Cutcliffe said of the software division. Still, "I think
the sale is probably a smart move, because that's what the Street loves to see: a company getting very focused on their business."
Thanks to the software sale, Roxio is now trading at more than half of its cash value, noted Mark Mowrey, an analyst with Al Frank Asset Management in Laguna Beach, Calif. The company has $62.7 million, or $1.81 a share, in cash on its balance sheet.
"It's definitely undervalued," Mowrey said of Roxio, which also inked a multiyear marketing agreement with electronics retailer
. "This is why we buy these sorts of companies -- because they've got so much cash that they have the ability to be very maneuverable in their operation."
However, whether Roxio has enough cash to outmaneuver rivals such as Microsoft that have even more powerful balance sheets remains to be seen. For Audible, on the other hand, it's a need to show it can control customer acquisition costs.
Which company will become a more successful player in the digital media arena? Stay tuned.