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Digital Audio Insider is David Harrell's blog about the economics of music and other digital content. I write from the perspective of a musican who has self-released four albums with the indie rock band the Layaways.

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September 19, 2006

Napster News, Profits from Breakage
by David Harrell
Napster News, Profits from Breakage
Napster is in the news today after announcing it has hired UBS to help evaluate third-party interest and/or strategic alliances.

I didn't realize (or maybe I had just forgotten) that Napster (NAPS) is a public company until I did a little research on the firm last week to respond to a comment to this post. Which means that all the details about the firm's finances are available in its public SEC filings.

According to its most recent 10K filing, Napster's online subscription service itself generated more than $25 million in gross profits for the fiscal year ending March 31, after royalty payments, bandwidth, hosting, etc. And Napster managed to increase its subscriber base to 606,000 as of March 31, 2006 from 412,000 as of March 31, 2005.

But Napster is spending a TON of money to acquire those subscribers ($51.7 million in sales and marketing), and for R&D ($13.1 million) and administrative costs ($20.8 million). All of which adds up to a net loss of nearly $55 million on sales of $94.7 million for the 2006 fiscal year. (Today's press release talks about annual revenues and Napster's strong cash reserves, but doesn't mention how much money the firm is losing each year.)

I didn't see any specific stats in the filings regarding subscriber retention/churn. That seems to be a (the?) key factor for any potential profitability for Napster. As long as it has to spend so much to maintain its subscriber base, profitability seems unlikely.

There was one very interesting tidbit in the firm's most recent 10Q quarterly filing, though. Those pre-paid cards are turning out to be very profitable because some purchasers never get around to using them:
Revenues from prepaid cards and promotions are deferred and then recognized as (i) tracks are downloaded by the end users, (ii) if redeemed for a subscription, over the subscription period or (iii) when Napster has no further obligation to provide services or refund the associated prepayments ("prepaid card breakage"). As of June 30, 2006, we have not had sufficient historical experience to estimate prepaid card breakage rates, so we recognize prepaid card breakage when our obligation to honor the redemption of the prepaid cards or promotions has legally expired. During the first quarter of fiscal 2007, based on the resolution of certain legal restrictions associated with previously sold prepaid cards, we recognized $2.2 million of prepaid card breakage, of which $1.9 million relates to cards that were subject to expiration based on their term prior to 2007 but had other legal restrictions that precluded our recognition of revenue. The remaining $300,000 was related to cards that expired during the first quarter of fiscal 2007.
I wonder if such "breakage" might turn out to be a profit center for the other subscription services and online stores.


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