Napster 10-Q 2008
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended December 31, 2007
Commission File Number: 000-32373
(Exact name of Registrant as specified in its charter)
9044 Melrose Avenue
Los Angeles, California 90069
(Address of principal executive offices, including zip code)
Registrants telephone number, including area code: (310) 281-5000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of January 31, 2008, there were approximately 46,000,000 shares of the registrants Common Stock outstanding, par value $0.001.
TABLE OF CONTENTS
Cautionary Note regarding Forward-Looking Statements
In addition to current and historical information, this Quarterly Report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to our future operations, prospects, potential products, services, developments and business strategies. These statements can, in some cases, be identified by the use of terms such as may, will, should, could, would, intend, expect, plan, anticipate, believe, estimate, predict, project, potential, or continue or the negative of such terms or other comparable terminology. This Quarterly Report includes, among others, forward-looking statements regarding:
These statements involve certain known and unknown risks, and uncertainties that could cause our actual results to differ materially from those expressed or implied in our forward-looking statements. Such risks and uncertainties include, among others, those listed in Part II Item 1A, Risk Factors of this Quarterly Report on Form 10-Q. We do not intend, and undertake no obligation, to update any of our forward-looking statements after the date of this Quarterly Report to reflect actual results or future events or circumstances.
Napster, Napster Mobile, Napster To Go and Napster Light are either trademarks or registered trademarks of Napster, Inc. or its subsidiaries in the United States and/or other countries. All other trademarks are owned by their respective owners.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
The accompanying notes are an integral part of these condensed consolidated financial statements.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
The accompanying notes are an integral part of these condensed consolidated financial statements.
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN
The accompanying notes are an integral part of these condensed consolidated financial statements.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these condensed consolidated financial statements.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1BASIS OF PRESENTATION
Basis of Presentation
The unaudited condensed consolidated financial statements have been prepared by Napster, Inc., a Delaware corporation (Napster or the Company), pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). The condensed consolidated balance sheet as of March 31, 2007, was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States. Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with generally accepted accounting principles in the United States have been condensed or omitted pursuant to such rules and regulations. However, Napster believes that the disclosures are adequate to make the information presented not misleading. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes included in Napsters Annual Report on Form 10-K for the year ended March 31, 2007.
The condensed consolidated financial statements reflect all adjustments, which include only normal, recurring adjustments, that are, in the opinion of management, necessary to state fairly the results for the periods presented. The results for such periods are not necessarily indicative of the results to be expected for the full year.
The preparation of condensed consolidated financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
Our fiscal year end is March 31, and our fiscal quarters end on June 30, September 30 and December 31. Unless otherwise stated, all dates refer to our fiscal year and fiscal periods.
Advertising costs are expensed as incurred and were $1.4 million and $3.9 million for the three and nine months ended December 31, 2007, respectively, and $6.9 million and $19.8 million for the three and nine months ended December 31, 2006, respectively.
On April 1, 2007, the Company adopted the provisions of FASB Interpretation 48, Accounting for Uncertainty in Income Taxesan interpretation of FASB Statement No. 109 (FIN 48), which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the recognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. The adoption of FIN 48 resulted in no adjustment to beginning accumulated deficit.
The Company files its tax returns as prescribed by the tax laws of the jurisdictions in which it operates. The Company is currently open to audit under the statue of limitations by the Internal Revenue Service for the years ended March 31, 2004 through 2007. State income tax returns for the Company and its subsidiaries are open to audit under the statue of limitations for the years ended March 31, 2003 through 2007. The Companys foreign operations are open to audit under statute of limitations for the years ended March 31, 2004 through 2007.
The uncertain tax position balance as of December 31, 2007 was insignificant. The Company recognizes interest and/or penalties related to uncertain tax positions in income tax expense. No additional interest and penalties were accrued upon adoption of FIN 48. Interest and penalties accrued previously were immaterial as of December 31, 2007. The Company does not anticipate significant changes to total uncertain tax positions due to the settlement of examinations or the expirations of statutes of limitations during the next twelve months.
NOTE 2CASH, CASH EQUIVALENTS AND INVESTMENTS
Cash and Cash Equivalents
Napsters cash and cash equivalents at fair value consist of the following (in thousands):
Napsters short-term investments at fair value consist of the following (in thousands):
Napsters investments in marketable securities and short-term investments are all considered available for sale. The fair values of these investments approximate carrying value. Realized and unrealized gains and losses on investments are determined on the specific identification method.
All $39.9 million and $36.4 million of short-term investments at December 31, 2007 and March 31, 2007, respectively, mature in less than one year.
Realized gains and losses, amortization and accretion on cash equivalents and short-term investments, net, totaled $338,000 and $1.1 million for the three and nine months ended December 31, 2007, respectively, and $339,000 and $1.2 million for the three and nine months ended December 31, 2006, respectively. Gross realized losses on short-term investments for the three and nine months ended December 31, 2007 and 2006 were not significant.
Additionally, gross unrealized gains on cash equivalents and short-term investments were $22,000 and $2,000 as of December 31, 2007 and March 31, 2007, respectively, and gross unrealized losses on cash equivalents and short-term investments were $15,000 and $20,000 as of December 31, 2007 and March 31, 2007, respectively. Napster has determined that the gross unrealized losses on its available-for-sale securities as of December 31, 2007 are temporary in nature.
NOTE 3 BALANCE SHEET DETAIL
Prepaid expenses and other current assets (in thousands)
Identifiable intangible assets, net (in thousands)
Amortization of identifiable intangible assets was $862,000 and $3.5 million for the three and nine months ended December 31, 2007, respectively, and zero for the three and nine months ended December 31, 2006, respectively. The customer intangible is being amortized based on its estimated usage over a five-year period.
Accrued liabilities (in thousands)
NOTE 4STOCKHOLDERS EQUITY
The following table summarizes the activity relating to restricted stock awards (RSAs) and stock option grants for the nine months ended December 31, 2007:
As of December 31, 2007, there was $6.0 million and $520,000 of total unrecognized compensation expense related to unvested restricted stock awards and stock options, respectively, which is expected to be recognized over the weighted-average periods of 2.95 and 1.29 years, respectively. The total fair value on the vesting date of restricted stock awards that vested during the nine months ended December 31, 2007 and 2006 was $1.7 million and $624,000, respectively.
A total of 5.5 million and 5.8 million common equivalent shares were excluded from the calculation of weighted average shares as of December 31, 2007 and 2006, respectively, because their effect would have been anti-dilutive.
NOTE 5GEOGRAPHIC INFORMATION
The following table presents net revenues from continuing operations by country based on the entity that received the revenue (in thousands):
Cash and Investments
The following table presents cash, cash equivalents and short-term investments held in entities organized in the following legal jurisdictions (in thousands):
Napster does not anticipate that it will incur any material U.S. income or foreign withholding taxes when cash is repatriated from the foreign entities to the United States.
NOTE 6COMMITMENTS AND CONTINGENCIES
Napster and Napster, LLCs predecessor, Pressplay, have been notified by a number of companies that the Pressplay and Napster digital music services may infringe patents owned by those companies. Napster is investigating the nature of these claims and the extent to which royalties may be owed by Napster and Pressplay to these entities. The ultimate resolution of these claims cannot be determined at this time.
On October 8, 2004, SightSound Technologies, Inc. (SightSound) filed a lawsuit against Napster and Napster, LLC in U.S. District Court for the Western District of Pennsylvania (Case No. 2:04-cv-1549) alleging infringement of certain of its patents by the Napster service. SightSound is demanding monetary damages and injunctive relief. Napster was served with the complaint in the lawsuit on November 5, 2004. Napster answered the complaint and filed an application with the United States Patent and Trademark Office for reexamination of the patents. The court proceedings have been administratively closed pending the outcome of Napsters reexamination application. In or around November 2005, SightSound sold the patents in question to a subsidiary of General Electric for an undisclosed amount. The Patent Office rejected all of the claims of each of the patents. In June 2007, General Electric filed an appeal of this decision with the Patent Office.
On August 5, 2005, Ho Keung Tse filed suit against Apple Computer, Inc., Napster, MusicMatch, Inc., Sony Connect, Inc., Yahoo, Inc. and RealNetworks, Inc. in U.S. District Court for the District of Maryland (Case No. 1:05-cv-2149) alleging infringement of U.S. Patent No. 6665797 by the defendants respective music distribution services. Mr. Tse is demanding monetary damages and injunctive relief. The defendants have formed a joint defense group and intend to defend themselves vigorously. The defendants were granted change of venue to the District of Northern California (Case No. 4:06- cv-06573-SBA), where the court stayed the litigation pending the reexamination of the related patent by the United States Patent and Trademark Office.
On December 15, 2005, MCS Music America, on behalf of itself and other publishers filed suit against Napster in U.S. District Court for the Middle District of Tennessee alleging that Napster had unlawfully distributed copyrighted musical compositions owned by the plaintiffs (Case No. 3:05-cv-1053). In November 2006, the plaintiffs sought and were granted a voluntary dismissal without prejudice. On November 15, 2006, Napster filed a complaint for declaratory relief against the former plaintiffs in Case No. 3:05-cv-1053 in the U.S. District Court for the Central District of California (Case No. 2:06-cv-7285). On December 15, 2006, the same plaintiffs re-filed their suit against Napster in U.S. District Court for the Middle District of Tennessee (Case No. 3:06-cv-01197). On March 7, 2007, the judge in the Tennessee case granted Napsters motion to transfer that case to the Central District of California as well. MCS is demanding monetary damages and injunctive relief. Napster intends to defend itself vigorously.
On November 20, 2006, Antor Media Corporation filed suit against Napster and others in U.S. District Court for the Eastern District of Texas (Case No. 5:06-cv-270) alleging infringement of U.S. Patent No. 5734961 by the defendants respective products and services. Antor is demanding monetary damages and injunctive relief. The defendants have formed a joint defense group and intend to defend themselves vigorously. On December 14, 2007, the United States Patent and Trademark Office issued an office action rejecting all of the claims relating to such patent and limiting Antors time to appeal such rejection.
On December 29, 2006, Intertainer, Inc. filed suit against Napster and others in U.S. District Court for the Eastern District of Texas (Case No. 2:06-cv-549) alleging infringement of U.S. Patent No. 6925469 by the defendants respective products and services. Intertainer is demanding monetary damages and injunctive relief. Napster has joined a joint defense group, and the parties intend to defend themselves vigorously.
On September 11, 2007, Premier International Associates filed suit against Napster and others in U.S. District Court for the Eastern District of Texas (Case no. 2: 07-cv-396) alleging infringement of U.S. Patent Nos. 6,243,725 and 6,763,345 by the defendants products and services. Premier is demanding monetary damages and injunctive relief. Napster has joined a joint defense group, and the parties intend to defend themselves vigorously.
For each of the above matters, management believes that it is not currently possible to estimate the impact, if any, that the ultimate resolution of these matters will have on Napsters business, results of operations, financial position or cash flows.
Napster is a party to other litigation matters and claims from time to time in the ordinary course of its operations, including copyright infringement litigation for which it is entitled to indemnification by content providers. While the results of such litigation and claims cannot be predicted with certainty, Napster believes that the final outcome of such matters will not have a material adverse impact on its business, financial position, cash flows or results of operations.
In December 2004, as part of the sale of substantially all of the assets and liabilities of CSD to Sonic, Napster agreed to indemnify Sonic for unpaid tax liabilities with respect to any tax year ended on or before December 17, 2004 (or for any other tax year to the extent allocable to the portion of such period beginning before and ending on December 17, 2004), to the extent such tax liabilities neither are reflected in the closing working capital calculation pursuant to the sale agreement nor create a realized reduction in Sonics tax liabilities. Napster also agreed to indemnify Sonic for damages that relate to certain other tax-related matters, as described in the sale agreement. No limitation is set forth on the period of time by which a claim must be made pursuant to the foregoing indemnities nor is there a specified limitation on the maximum amount of potential future payments.
Obligations to content and distribution providers
Napster has certain royalty commitments associated with the licensing of the music content. Future payments under these content publishing agreements are due to partners based upon net revenues and online music distribution volumes.
NOTE 7RECENT ACCOUNTING PRONOUNCEMENTS
In December 2007, the Financial Accounting Standard Board issued SFAS No. 141(R), Business Combinations, which replaces SFAS No. 141, Business Combination. SFAS No. 141(R) retains the underlying concepts of SFAS No. 141 in that all business combinations are still required to be accounted for at fair value under the acquisition method of accounting, but SFAS No. 141(R) changed the method of applying the acquisition method in a number of significant aspects.
SFAS No. 141(R) is effective on a prospective basis for all business combinations for which the acquisition date is on or after the beginning of the first annual period subsequent to December 15, 2008, with the exception of the accounting for valuation allowances on deferred taxes and acquired tax contingencies under SFAS No. 109. SFAS No. 141(R) amends SFAS No.109 such that adjustments made to valuation allowances on deferred taxes and acquired tax contingencies associated with acquisitions that closed prior to the effective date of FAS No. 141(R) would also apply the provisions of FAS 141(R). Early adoption is not allowed.
The adoption of SFAS 141(R) is not expected to have a material impact on the Companys consolidated financial position, cash flows and results of operations,
The following discussion should be read in conjunction with the financial statements and notes thereto included elsewhere in this Quarterly Report. The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from the results contemplated by these forward-looking statements due to certain factors, including those discussed in Part II Item 1A Risk Factors and elsewhere in this Quarterly Report.
Managements Discussion and Analysis of Financial Condition and Results of Operations is organized as follows:
Napster, among the most recognized brands in online music, is a leading provider of digital music for the consumer market. Our digital music distribution services enable fans to sample, listen to, subscribe to and purchase from one of the worlds largest and most diverse online music catalogs utilizing a secure and legal platform. Napster users have access to songs from all major labels and hundreds of independent labels, and are able to stream or download those songs either over the Internet or over wireless networks.
Subscribers to the Napster PC service receive unlimited access to our more than 5 million song catalog, and have the ability to download music with high quality sound and enjoy their music in an advertising-free environment, as well as access many features including radio, Billboard charts and many community features. In addition, Napster subscribers are able to enjoy their music on a variety of media across personal computers (including directly from a web browser with no software required on PC, Mac, and Linux platforms), CDs, MP3 players, music-enabled cellular phones and digital media devices for the living room.
Napster Mobile, our service available over certain carrier wireless networks, gives members access to over-the-air downloads, ringtones, wallpapers and other personalization products, as well as our extensive song catalog.
Napster PC and Mobile services are currently available in North America, Europe and Japan.
Our overall strategy is to attain profitability by continuing to pursue and execute strategic partnerships, continuing to innovate by investing in new services and technologies, such as delivery of music in MP3 format, and continuing to reduce our subscriber customer acquisition cost and cancellations.
We derive our primary revenues from online subscriptions and permanent music downloads. The paid Napster service offers subscribers on-demand access to a wide variety of music that can be streamed or downloaded, as well as the ability to purchase individual tracks or albums on an a la carte basis. Subscription and permanent download fees are paid by end user customers in advance via credit card, online payment systems or redemption of pre-paid cards, gift certificates or promotional codes. Napster also periodically licenses merchandising rights and resells hardware that our end users may utilize to store and play their digital music content.
The market for digital music is growing rapidly. We expect our digital music distribution business to continue to grow as the industry expands and, in particular, once new compatible devices become available. The digital music market is highly competitive and we expect competition to continue to increase in the future as the market expands. We believe that our unique brand, technology and feature set positions us favorably with respect to many of our competitors.
From the acquisition of Pressplay on May 19, 2003 through the end of fiscal 2007, our digital music distribution business operated at a loss and with negative cash flow. During the first nine months of fiscal 2008, we operated at a loss, but achieved a positive cash flow. We expect to continue to operate at a loss near term due to our significant investments to enhance service capabilities, market our products and grow worldwide. We expect our existing cash resources to be sufficient to fund our operations for at least the next twelve months.
Critical Accounting Policies and Estimates
Managements Discussion and Analysis of Financial Condition and Results of Operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from our estimates.
An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used or changes in the accounting estimate that are reasonably likely to occur could materially change the financial statements. Except as indicated below, there have been no significant changes during the nine months ended December 31, 2007 to the items that we disclosed as our critical accounting policies and estimates in Managements Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended March 31, 2007.
On April 1, 2007, the Company adopted the provisions of FASB Interpretation 48, Accounting for Uncertainty in Income Taxesan interpretation of FASB Statement No. 109 (FIN 48), which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the recognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. The adoption of FIN 48 resulted in no adjustment to beginning accumulated deficit.
Significant management judgment is required in determining our uncertain tax positions. While Napster bases its estimates on historical experience and various other assumptions that management believes to be reasonable under the circumstances, actual results may differ from these estimates and, as a result, could have a material impact on our financial position, results of operations and cash flows.
Results of Operations
Our fiscal year ends on March 31, and our fiscal quarters end on June 30, September 30 and December 31. Unless otherwise stated, all dates refer to our fiscal year and fiscal periods.
The financial information presented in this Quarterly Report is not necessarily indicative of our financial position, results of operations or cash flows in the future.
The following table sets forth, for the periods indicated, the summary of our revenues (in thousands, except percentages):
Service revenues increased in the three and nine months ended December 31, 2007 as compared to the corresponding periods in fiscal 2007 primarily due to the increase in our subscriber base year over year and the launch of new product lines. Paid subscribers increased to approximately 743,000 at December 31, 2007 from approximately 566,000 at December 31, 2006. A significant portion of this increase is due to the transition of the AOL Music Now subscribers to our service in March 2007. Additionally, we launched our wireless product line during the fall of 2006, resulting in increased wireless revenues year over year.
The $4.7 million increase in service revenues for the three months ended December 31, 2007 compared to the prior year quarter is primarily due to (1) a $7.5 million increase in subscription and wireless revenue, which included $1.9 million non-recurring subscription revenue breakage and (2) $849,000 non-recurring royalty revenue breakage. These revenue increases were offset by a $1.5 million decrease in download revenue and a non-recurring benefit of $2.1 million prepaid card breakage recognized in the third fiscal quarter of fiscal 2007.
The $14.3 million increase in service revenues for the first nine months of fiscal 2008 as compared to the corresponding period in fiscal 2007 is the result of (1) a $22.1 million increase in subscription and wireless revenue, of which $2.0 million represents the net increase for year-to-date non-recurring items year over year, (2) offset by a $3.8 million decrease in download revenues year over year and (3) the fact that we recognized a total benefit of $4.0 million in prepaid card breakage in the first nine months of fiscal 2007, with no prepaid card breakage revenue in the first nine months of fiscal 2008.
Paid subscribers at December 31, 2007 decreased less than 1% from approximately 750,000 at September 30, 2007 to 743,000 at December 31, 2007. This decrease occurred because new added subscribers were not sufficient to offset our normal cancellations during the period, primarily due to delays in the delivery of new compatible wireless handset devices. We expect our subscriber growth to resume with anticipated growth in the number of available compatible devices.
Excluding the $2.8 million of non-recurring revenue items in the third quarter, we expect fourth quarter service revenues to remain relatively flat quarter over quarter.
Product and Trademark License Revenues
Product and trademark license revenues decreased for the three months ended December 31, 2007 as compared to the corresponding period in fiscal 2007 primarily due to the timing of hardware promotion programs. Product and trademark license revenues increased for the nine months ended December 31, 2007 as compared to the corresponding period in fiscal 2007 primarily due to $700,000 of non-recurring trademark license revenue recognized due to the termination of a trademark license agreement in September 2007. We expect that product and trademark license revenues will continue to be a small portion of net revenues and fluctuate depending on the product promotions and trademark licenses that we enter into each quarter.
The following table sets forth, for the periods indicated, the summary of our revenues by geography (in thousands, except percentages):
Revenue in North America for the three and nine months ended December 31, 2007, as compared to the corresponding periods of fiscal 2007, increased primarily due to the increases in subscription and wireless revenues and the non-recurring revenues in both the third quarter of and year to date fiscal 2008, offset by the decrease in download revenue for the three and nine months ended December 31, 2007 and the fact that we recognized one-time prepaid card breakage revenue in fiscal 2007.
European subscription and download revenue increased in the three and nine months ended December 31, 2007 compared to the comparable prior year periods. The increases are primarily due to continuous overall growth of the online music market in Europe.
We anticipate that the proportion of revenue outside of the United States will fluctuate as a result of continued marketing activities and initiatives focused on world-wide customer growth and international expansion.
The following table sets forth, for the periods indicated, our gross margins (in thousands, except percentages):
Service gross margin is the profit from revenues after deducting the cost of royalties to content providers and publishers, technical support, bandwidth and hosting costs, depreciation and amortization of infrastructure related to the delivery of the services, and any other direct costs of providing the services. Product and trademark license gross margin is the profit from revenues after deducting the cost of products sold, order fulfillment services, product shipping costs and any other direct expenses to deliver the product or trademark licenses.
Service gross margin as a percentage of related revenue decreased two percentage points in the three months ended December 31, 2007 compared to the corresponding period of fiscal 2007 primarily due to the higher gross margin on non-recurring breakage revenues in fiscal 2007. Excluding non-recurring revenues and their associated cost of revenues, service gross margin was flat at 28% for both the three months ended December 31, 2007 and the same period of fiscal 2007. Non-recurring items excluded in the above calculation are the $2.8 million and $2.4 million of non-recurring breakage revenue during the three months ended December 31, 2007 and 2006, respectively, as well as the associated $870,000 of costs in the three months ended December 31, 2007.
Service gross margin decreased one percentage point during the nine months ended December 31, 2007 as compared to the corresponding period of fiscal 2007 primarily due to the non-recurring breakage revenues and cost of revenues recognized in both years. Excluding non-recurring revenues and their associated cost of revenues, service gross margin for the nine months ended December 31, 2007 and 2006 was 28% and 27%, respectively. The improvement was due to the shift of our revenue mix to a higher proportion of higher margin subscription revenues. Non-recurring items excluded in the above calculation are the 2.9 million and $4.9 million of non-recurring breakage revenue for the nine months ended December 31, 2007 and 2006, respectively, as well as the associated $870,000 of costs in the nine months ended December 31, 2007.
Product and trademark license gross margin as a percentage of related revenue during the three and nine months ended December 31, 2007 compared to the same periods of fiscal 2007, varies primarily due to the terms of hardware promotions and the volume of trademark licenses in each period. In addition, the improvement in product and trademark license gross margin percentage for the nine months ended December 31, 2007 as compared to the corresponding period of fiscal 2007 is due to the non-recurring trademark license revenue recognized in the second quarter of fiscal 2008 that had no associated cost of revenues.
Service headcount dedicated to maintaining content and providing customer care was 13 at December 31, 2007 and 2006.
Near term, we expect gross margins to decline because the significant third quarter non-recurring breakage revenues will not recur. Additionally, our gross margins will fluctuate to the extent that our direct costs increase and depending on our product mix.
We classify operating expenses as research and development, sales and marketing and general and administrative. Each category includes related expenses for salaries, employee benefits, incentive compensation, stock-based compensation, travel, telephone, communications, facility costs and professional fees. Our sales and marketing expenses include additional expenditures specific to the marketing group, such as public relations, advertising, trade shows, marketing collateral materials and subscriber acquisition costs, as well as expenditures specific to the sales group, such as commissions and referral fees paid to marketing partners. In addition, we include certain amortization of identifiable intangible assets as operating expenses.
The following table sets forth, for the periods indicated, our operating expenses (in thousands, except percentages):
Research and Development
Research and development (R&D) expenses consist primarily of salary, benefits (including stock-based compensation) and contractors fees for our development and other costs associated with the minor enhancements of existing products, development of new services or development of new features for existing services.
R&D expenses decreased for the three months ended December 31, 2007 as compared to the corresponding period of fiscal 2007, primarily due to lower personnel costs for the lower headcount in fiscal 2008.
R&D expenses decreased for the nine months ended December 31, 2007 as compared to the corresponding period of fiscal 2007. The decrease can be attributed to the facts that we had a lower headcount, utilized more of our internal resources on capitalizable projects in the second quarter and hired fewer outside contractors in fiscal 2008. Those decreases were offset by higher stock-based compensation expense as more stock grants were issued in the first quarter of fiscal 2008 and by a one-time reimbursement from Napster Japan for R&D projects recognized as a reduction in R&D costs in the second quarter of fiscal 2007.
Research and development headcount was 58 and 66 at December 31, 2007 and 2006, respectively.
We expect future research and development expenses to fluctuate depending on our level of investment in new product enhancements and on whether those development projects qualify for capitalization in accordance with generally accepted accounting principles.
Sales and Marketing
Sales and marketing expenses consist primarily of salary and benefits (including stock-based compensation) for sales and marketing personnel, referral fees paid to marketing partners, other subscriber acquisition costs, as well as costs associated with advertising and promotions.
Sales and marketing expenses decreased $4.2 million and $13.3 million in the three and nine months ended December 31, 2007, respectively, as compared to the corresponding periods of fiscal 2007, due to the reduction in fixed cost marketing programs and a shift to variable cost marketing programs with strategic distribution partners who are paid only when we acquire new trial or paying subscribers. The remaining $400,000 and $1.3 million decrease in sales and marketing expenses in the three and nine months ended December 31, 2007, respectively, is attributable to reduced personnel costs since we need fewer employees and outside contractors to manage the current marketing programs.
Sales and marketing headcount decreased to 29 at December 31, 2007 from 36 at December 31, 2006.
We expect sales and marketing expenses to fluctuate in the future as our subscriber growth fluctuates, because our most significant sales and marketing cost is incurred as we add new subscribers through our strategic partnerships.
General and Administrative
General and administrative expenses consist primarily of salary and benefits (including stock-based compensation) for executive and administrative personnel, professional services, administrative outsources and other general corporate activities.
General and administrative expenses decreased for the third quarter of fiscal 2008 as compared to the corresponding period of fiscal 2007 primarily due to a $450,000 decrease in personnel expense associated with the lower headcount and an approximately net $65,000 decrease in professional and administrative outsource fees year over year.
General and administrative expenses increased for the first nine months of fiscal 2008 as compared to the corresponding period of fiscal 2007 due to an approximately net $700,000 increase in administrative outsource fees year over year offset by a $500,000 decrease in personnel related expenses associated with lower headcount and associated costs.
General and administrative headcount, including all corporate general and administrative employees, was 39 at December 31, 2007 compared to 42 at December 31, 2006.
General and administrative expenses may increase in the near term as certain administrative outsource fees increase when revenues increase, and as we continue to incur costs to evaluate and defend against recent legal and other claims.
Amortization of Intangible Assets
Beginning March 2007, we had amortization expense associated with acquired customer intangible assets. Future amortization expense will reflect the pattern in which the economic benefits of that customer intangible asset are consumed.
Loss from Unconsolidated Entity
The fiscal 2007 loss from unconsolidated entity represents our 31.5% portion of the loss incurred by Napster Japan during the period, limited to the extent of our cumulative equity contributions. We recognized no loss in the first nine months of fiscal 2008 because our portion of the unconsolidated entitys losses exceed our cumulative equity contributions. We do not expect to record further losses from Napster Japan unless we contribute additional capital in the future. Napster, LLC has no obligation to fund future losses or provide additional capital contributions to Napster Japan. In the event that Napster Japan issues additional equity ownership in the future and we do not participate in the financing, our ownership interest in Napster Japan would be diluted.
Other Income, Net
Other income, net, consists primarily of interest income on our cash equivalents and short-term investments, realized gains (losses) on short-term investments, interest expense and other miscellaneous income.
Other income, net, decreased approximately $280,000 in the third quarter of fiscal 2008 as compared to the corresponding period of fiscal 2007 due primarily to $110,000 lower interest income as a result of our lower average cash and short-term investments balance, as well as $170,000 of higher foreign currency remeasurement losses, primarily due to the fluctuation in the value of the British Pounds against the Euro during the quarter.
Other income, net, decreased approximately $670,000 in the first nine months of fiscal 2008 as compared to the corresponding period of fiscal 2007 due primarily to lower interest income on a lower average cash and short-term investments balance and higher foreign currency remeasurement losses, offset by a $638,000 benefit recognized upon the resolution of contingencies related to the Roxio spin off from Adaptec in the first quarter of fiscal 2008.
We expect interest and investment income, net, to vary in the future due to investment rate changes, foreign currency fluctuations and other non-recurring items.
Income Tax Provision
We have recorded a valuation allowance to reduce deferred tax assets to the amount we believe is more likely than not to be realized. In the event that deferred tax assets would be realizable in the future in excess of the net recorded amount, an adjustment to the valuation allowance on deferred tax assets would increase income in the period such determination was made.
During January 2005, following the divestiture of CSD, which utilized substantially all of our tax operating losses, Napster made a tax election to step up the basis in Pressplay goodwill for tax purposes. As a result, the Pressplay goodwill is deductible for tax purposes, which creates a tax timing difference that is presented as a deferred tax liability and deferred tax expense. As realization of this taxable temporary difference is not assured, a net tax expense related to this item is recorded.
The tax provisions in both years represent primarily state franchise taxes, foreign taxes and the timing difference related to the Pressplay goodwill. We are subject to various tax rates in the jurisdictions in which we do business. Our tax provision does not take into account any future benefit from loss carryforwards, which may be realized if we again achieve profitability and begin generating taxable income.
In the near term, we expect to continue to incur operating losses from operations, and therefore to have minimal tax provisions other than the timing difference related to the Pressplay goodwill.
Income from Discontinued Operations
Income from discontinued operations for the three and nine month periods ended December 31, 2006 represents the net tax benefit from the favorable resolution of previously provided tax contingencies related to CSD, which is considered a discontinued operation.
Liquidity and Capital Resources
At December 31, 2007, Napster had $69.3 million in cash, cash equivalents and short-term investments. These amounts consist principally of commercial paper, corporate securities, U.S. government securities, municipal securities, asset backed securities and money market securities. This balance represents a $2.8 million increase as compared to cash, cash equivalent and short-term investments at March 31, 2007.
Our primary ongoing source of cash is receipts from revenues. The primary uses of cash are payroll (salaries and related benefits), general operating expenses (marketing, travel and office rent), payments to content providers, payments for products held for resale, and purchases of property and equipment, including software development costs.
We have significant non-cash expenditures, such as depreciation and amortization, amortization of prepaid marketing expenses, stock based compensation charges and deferred tax expense. We also have significant non-cash changes in working capital, such as accruals for music publishing fees, for which rates have not been agreed and thus only partial payments are being made. If we had been required to make regular quarterly payments of the music publishing fees, our cash flows in each of the first three quarters of fiscal 2008 would have been slightly negative.
For fiscal 2008, provided that the music publishing fee rates are not finalized and presuming that we have no other large unusual cash payments, we expect to reflect cash flows near or above breakeven. However, once music publishing fee rates are established, we will be obliged to make a significant one-time payment for historical music publishing fees, and we will likely be required to make full regular payments. At that time, our cash flows from operations may become negative.
Our working capital was $37.0 million at December 31, 2007 compared to $41.0 million at March 31, 2007.
We believe that the liquidity provided by existing cash, cash equivalents and short-term investments will provide sufficient capital to meet our requirements for at least the next 12 months. Napster operates and will continue to operate in the near term at a loss. However, because of our significant non-cash expenses and changes in working capital, we expect to have positive or near breakeven cash flows near term.
We do not currently hold any debt. Accordingly, we have not been exposed to near-term adverse changes in interest rates or other market prices. We may, however, experience such adverse changes if we incur debt or hold other derivative financial instruments in the future.
The following table sets forth, for the periods indicated, the components of cash flow activities (in thousands):
Cash provided by (used in) operating activities is driven by our net loss, adjusted for non-cash items, and change in operating assets and liabilities. Non-cash adjustments include depreciation and amortization, amortization of prepaid marketing expenses, stock-based compensation expense, deferred income taxes and loss in unconsolidated entities. Other cash changes in operating assets and liabilities include the deferral of revenue, vendor prepayments, and ongoing payment and collection of trade payables and receivables.
Cash provided by (used in) investing activities is primarily attributable to purchases and sales of short-term investments, investment in (return on investment from) unconsolidated entity, proceeds from divestitures and capital expenditures.
Cash provided by (used in) financing activities is driven by our financing activities relating to employee stock plans, principal payments of long-term debts and equity financing.
The $29.2 million increase in net cash provided by operating activities in the first nine months of fiscal 2008 compared to the first nine months of fiscal 2007 is due to (1) the $16.2 million lower net loss in the first nine months of fiscal 2008, (2) $4.8 million of additional non-cash expenses in the first nine months of fiscal 2008, related primarily to amortization of assets recorded as part of the customer acquisition in March 2007, (3) $4.1 million less non cash revenues recognized in the first nine months of fiscal 2008, related primarily to prepaid card breakage revenue recognized in the first nine months of fiscal 2007, (4) $3.4 million of increased accruals for music publishing and content fees on higher revenues in the first nine months of fiscal 2008 and (5) an approximately $700,000 net increase in other changes in working capital items.
The decrease in net cash provided by investing activities in the first nine months of fiscal 2008 compared to fiscal 2007 is primarily due to the fact that, after funding the $1.2 million of capital expenditures in the first nine months of fiscal 2008, we moved available funds from cash-equivalent investments to favorable yield short-term investments. During the first nine months of fiscal 2007, we received the $2.2 million cash receipt from Sonic related to the divestiture of CSD in short-term investments and utilized approximately $9 million of short-term investments to fund operations.
Financing activities in both fiscal 2008 and 2007 were due to required minimum tax withholding on employee stock plan activity.
Off-Balance Sheet Arrangements
As of December 31, 2007, we did not have any off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.
Recent Accounting Pronouncements
For recent accounting pronouncements, see Note 7 Recent Accounting Pronouncements to the condensed consolidated financial statements appearing in Item 1, Part I to this Quarterly Report, which are incorporated by reference into this Item 2, Part I.
Interest Rate Risk
The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. We maintain our cash, cash equivalents and short-term investments with high quality financial institutions and, as part of our cash management process, we perform periodic evaluations of the relative credit standing of these financial institutions. Amounts deposited with these institutions may exceed federal depository insurance limits. In addition, the portfolio of investments conforms to our policy regarding concentration of investments, maximum maturity and quality of investment.
Some of the securities in which we have invested may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline in value. To reduce this risk, we maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, corporate bonds, U.S. agencies securities, asset-backed securities and money market funds. In general, money market funds are not subject to interest rate risk because the interest paid on these funds fluctuates with the prevailing interest rate. All of our short-term investments mature in less than one year.
At December 31, 2007, all $39.9 million of our short-term investments are subject to market risk and mature within one year. The weighted-average yield of those short-term investments was 5.15% at December 31, 2007. Our cash equivalents are invested in commercial paper and money market funds, which are not considered subject to market risk because those funds are not subject to significant interest rate risk due to their short maturities.
We do not currently hold any variable interest rate debt. Accordingly, we have not been exposed to near-term adverse changes in interest rates or other market prices. We may, however, experience such adverse changes if we incur debt or hold other derivative financial instruments in the future.
Financial instruments that potentially subject us to significant concentrations of credit risk consist principally of trade accounts receivable and accounts payable.
Exchange Rate Risk
We market our Napster service in North America, Japan and Europe, resulting in transactions denominated in U.S. dollars, Canadian dollars, United Kingdom pounds, Euro, Swiss Francs and Japanese yen. As such, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets.
Transactions denominated in currencies other than the functional currency of the legal entity are remeasured to the functional currency of the legal entity at the period-end exchange rates. Any associated currency re-measurement gains and losses are recognized in current operations.
For our foreign subsidiaries whose functional currency is the local currency, we translate assets and liabilities to U.S. dollars using period-end exchange rates and translate revenues and expenses using average exchange rates during the period. Exchange gains and losses arising from translation of foreign entity financial statements are included as a component of other comprehensive income (loss).
Cash and cash equivalents are predominantly denominated in U.S. dollars. As of December 31, 2007 we held the equivalent of $3.8 million U.S. dollars of cash and cash equivalents in United Kingdom pounds, $2.4 million in Euro and approximately $996,000 in other foreign currencies.
Evaluation of Disclosure Controls and Procedures
Our management has evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures were effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that our disclosure controls and procedures were also effective to ensure that information required to be disclosed in such reports is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure.
Changes in Internal Control Over Financial Reporting
During the quarter ended December 31, 2007, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART IIOTHER INFORMATION
For legal proceedings, see Note 6 Commitments And Contingencies to the condensed consolidated financial statements appearing in Item 1, Part I to this Quarterly Report, which is incorporated by reference into this Item 1, Part II.
We have updated the risk factors discussed in Item 1A of our Annual Report on Form 10-K for the year ended March 31, 2007. We do not believe any of the updates constitute material changes from the risk factors previously disclosed in that report. For convenience, our risk factors, as updated, are included below in this Item 1A.
In addition, investing in our common stock involves a high degree of risk. You should carefully consider the risks described below and the other information in this Quarterly Report. If any of the following risks occur, our business could be materially harmed, and our financial condition and results of operations could be materially and adversely affected. As a result, the price of our common stock could decline, and you could lose all or part of your investment.
Our digital music distribution business has a limited operating history and a history of losses and may not be successful.
On May 19, 2003, we acquired substantially all of the ownership interests of Napster, LLC (f/k/a Pressplay). We used the Pressplay-branded service as a technology platform to roll-out our online music services division in October 2003. The business models, technologies and market for digital music services are developing. Prior to our acquisition of Napster, LLC, consumer adoption and usage of the Pressplay-branded service had not been significant. You should consider our business and prospects in light of the risks, expenses and difficulties encountered by companies in their early stage of development.
Our digital music distribution business has experienced significant net losses since its inception and, given the significant operating expenditures associated with our business plan, we expect to incur net losses for at least the next twelve months and will likely continue to experience net losses thereafter. No assurance can be made that our paid Napster service or the free music service will ever contribute net income to our statement of operations. During the period beginning April 1, 2003, just prior to our acquisition of Pressplay in May 2003, through December 31, 2007, we incurred approximately $204.5 million of after tax losses from continuing operations.
The success of our paid Napster service depends upon our ability to add new subscribers and reduce churn.
We cannot assure you that we will be able to attract new subscribers or that existing subscribers will continue to subscribe. Trial subscribers and users of our free music service may choose not to become paid subscribers, and paid subscribers may decide to cancel their subscriptions, for many reasons including a perception that they do not use the services enough to justify the expense or that the service does not provide enough value or availability of content relative to our competition. In addition, any reduction in our current level of marketing and advertising will likely result in a reduction in the number of new trial and paid subscribers.
The early stages of subscription services such as ours are characterized by higher than normal churn rates. Existing paid subscribers may cancel their subscriptions to the Napster service for many reasons, including those described above in this risk factor. In addition, there is significant seasonality in our subscriber numbers, primarily due to softness in customer acquisition during the summer months when consumers spend less time online. While we have successfully reduced churn in the past, we cannot guarantee that we will be able to further reduce subscriber churn or even maintain existing levels.
If we are unable to add new paid subscribers and reduce churn rates we may be unable to achieve a profitable business model.
The results of our asset purchase agreement with AOL Music Now, LLC and our asset acquisition and advertising agreement with AOL, LLC may not meet our expectations.
On January 11, 2007, we entered into an Asset Purchase Agreement with AOL Music Now, LLC and AOL, LLC, collectively referred to as AOL, and an Advertising Agreement with AOL, LLC, collectively the Agreement. Under the terms of the Agreement, Napster, LLC paid $11.2 million to AOL in exchange for all of the subscribers to AOLs Music Now service, together with certain related assets and liabilities. Additionally, Napster, LLC was granted certain exclusive advertising rights throughout the AOL Music Channel for one year, subject to renewal upon the achievement of certain milestones, and AOL guaranteed to deliver a minimum amount of advertising impressions to us. On March 15, 2007, we transferred more than 225,000 former AOL Music Now customers to the Napster service pursuant to the Agreement. If these former AOL Music Now customers do not stay on the Napster service as long as we have estimated, our revenues will not grow as expected and our business will be harmed.
We experience fluctuations in our quarterly operating results, which may cause our stock price to decline.
Our quarterly operating results may fluctuate from quarter to quarter. We cannot reliably predict future revenue and margin trends and such trends may cause us to adjust our operations. Other factors that could affect our quarterly operating results include:
We rely on the value of the Napster brand, and our revenues could suffer if we are not able to maintain its high level of recognition in the digital music sector.
We believe that maintaining and expanding the Napster brand is an important aspect of our efforts to attract and expand our user and advertiser base. We employ a broad branding program to ensure that our position in the digital music sector continues to be strongly associated with the Napster name. Promotion and enhancement of the Napster brand will depend in part on our ability to provide consistently high-quality products and services. If we are not able to successfully maintain or enhance consumer awareness of the Napster brand or, even if we are successful in our branding efforts, if we are unable to maintain or enhance customer awareness of the Napster brand in a cost effective manner, our business, operating results and financial condition would be harmed.
We face significant competition from traditional retail music distributors, from emerging paid online and mobile music services delivered electronically such as ours, and from free peer-to-peer services.
We face significant competition from traditional retail music distributors, as well as online retailers such as Amazon.com. These retailers may include regional and national mall-based music chains, international chains, deep-discount retailers, mass merchandisers, consumer electronics outlets, mail order, record clubs, independent operators and online physical retail music distributors, some of which have greater financial and other resources than we do. To the extent that consumers choose to purchase media in non-electronic formats, it may reduce our sales, reduce our gross margins, increase our operating expenses and decrease our profit margins in specific markets.
Our digital music distribution services competitors currently include Apple Computers iTunes Music Store, RealNetworks, Incs Rhapsody America, Yahoo! Music Unlimited and eMusic. Other competitors include online and offline retailers such as Amazon.com and WalMart, satellite radio providers such as XM and Sirius, and music services offered directly by mobile operators such as Verizon (via its V-cast service) and Sprint (through its Music Store). Internationally we currently compete with OD2, Puretracks, Omnifones Music Station, 3 Music Store and Vodafones music offerings, among others, as well as with a number of the other competitors described above.
Our digital music distribution business also faces significant competition from free peer-to-peer services, such as Limewire, KaZaA, Morpheus, BitTorrent and a variety of similar services that allow computer users to connect with each other and to copy many types of program files, including music and other media, from one anothers hard drives, all without securing licenses from content providers. While the U.S. Supreme Court has found that Grokster may violate copyright laws, the court did not establish that such services are necessarily liable for copyright infringement, opting instead for a fact-based analysis of the services efforts to promote copyright infringement. Additionally, enforcement efforts against those in violation have not effectively shut down these services, and there can be no assurance that these services will ever be shut down. We are also impacted by free services operated out of foreign jurisdictions, such as Russia, where copyright and other laws may be less stringently interpreted and/or enforced. The ongoing presence of these free services substantially impairs the marketability of legitimate services, regardless of the ultimate resolution of their legal status. Finally, several high profile peer-to-peer services, such as Limewire, have started to or announced their intention to move to legally (or partially legally) licensed business models, while still using their peer-to-peer architecture. Many of these entities are well financed with significant installed user bases and if they are successful in moving their businesses to legal models, it could significantly increase our competitive pressure.
Many of our competitors have significantly more resources than we do, and some of our competitors may be able to leverage their experience in providing digital music distribution services or similar services to their customers in other businesses. We or our competitors may be able to secure limited exclusive rights to content from time to time. If our competitors secure significant exclusive content, it could harm the ability of our online music services to compete effectively in the marketplace.
In particular, some of our competitors offer other goods and services and may be willing and able to offer music services at a lower price than we can in order to promote the sale of these goods and services. If we lower our prices, our gross margins and operating results may be adversely affected. If we do not lower our prices, we may be unable to compete with discount services. This could harm the ability of our online music services to compete effectively in the marketplace.
Our advertising-supported music website competes, directly and indirectly, for advertisers, viewers, members, and content providers with publishers and distributors of traditional off-line media, such as television, radio and print, including those targeted to music, many of which have established or may establish websites, such as MTV. We face competition from general purpose consumer online services such as Yahoo, myspace.com, MSN and Google, each of which provides access to music-related content and services and from websites targeted to music related content, such as lastfm.com and pandora.com. We also face competition from social networking sites, such as iMeem.
Digital music distribution services in general are new and rapidly evolving and may not prove to be a profitable or even viable business model.
Digital music distribution services are a relatively new business model for delivering digital media over the Internet. It is too early to predict whether consumers will accept, in significant numbers, digital music services and accordingly whether the services will be financially viable. If digital music distribution services do not prove to be popular with consumers, or if these services cannot sustain any such popularity, our business and prospects would be harmed.
The emerging mobile music market faces significant, unique challenges.
We believe that growth in the mobile music services market is important to the future growth in our general digital music distribution services. We are investing in this area but face significant and unique challenges that could adversely affect our business.
There are a number of challenges that could impact the adoption rate of mobile platforms as a leading method of digital music purchase, including the rate of adoption of compatible mobile handsets, availability of high speed mobile data networks, adoption by mobile consumers of mobile data plans, development of content and digital rights management standards and technologies acceptable to content licensors and consumers, any pricing differential (both wholesale and retail) between content purchased over-the-air to a mobile device and purchased by other means, and the impact on the economics of the mobile music business of certain issued patents.
The success of our mobile music business is also currently contingent upon our ability to enter into strategic partnerships with leading mobile carriers. We cannot guarantee our ability to enter into or maintain these types of relationships. Additionally, certain major mobile carriers and handset manufacturers create and operate their own mobile music services that they offer directly to the consumer. Should this direct-to-consumer model become more prevalent, it could jeopardize our ability to competitively market our services.
If we are unsuccessful in meeting the challenges and complexities of mobile music distribution or are unsuccessful in securing additional customers for our services, our results of operations could be harmed.
We rely on content provided by third parties, which may not be available to us on commercially reasonable terms or at all.
We rely on third-party content providers, including music publishers and music labels, to offer online music content that can be delivered to users of our digital music distribution services. Rights to provide this content to our customers, particularly publishing rights, are difficult to obtain and require significant time and expense. In order to provide a compelling service, we must continue to be able to license a wide variety of music content to our customers with attractive usage rights such as CD recording, output to MP3 players, portable subscription, wireless and other rights. In addition, if we do not have sufficient breadth and depth of the titles necessary to satisfy increased demand arising from growth in our subscriber base, our subscriber satisfaction will be affected adversely.
Under copyright law, we are required to pay licensing fees for compositions embodied in digital sound recordings and for the sound recordings themselves that we deliver in our Napster service. U.S. copyright law generally does not specify the rate and terms of the licenses, which are determined by voluntary negotiations among the parties or, for certain compulsory publishing licenses where voluntary negotiations are unsuccessful, by a copyright royalty board (CRB), an administrative judicial proceeding supervised by the United States Copyright Office. Past copyright proceedings have resulted in rates for statutory webcasting that were significantly in excess of rates requested by webcasters. Currently, there is a CRB proceeding for mechanical licenses for digital distribution, including in a subscription context. We cannot predict the outcome of any negotiations or CRB proceedings. We may also elect to attempt to directly license compositions for our services, either alone or in concert with other affected companies. Further, the continued availability of blanket licenses for compositions used in international versions of the services is not assured, and for certain additional international services may be unclear. Therefore, our ability to negotiate appropriate licenses is uncertain.
Voluntarily negotiated rates for mechanical licenses with respect to streaming and conditional digital downloads with the Harry Fox Agency and National Music Publishers Association have not been agreed to, and we are currently operating under a standstill agreement until such rates are negotiated or determined by the copyright tribunal currently underway in the United States. Although a decision has been rendered by a United States district court that permanent downloads do not implicate a performance right that would trigger payment of public performance royalties to societies such as ASCAP or BMI, that decision could be appealed and the performing rights societies have not conceded the argument or entered into any agreements on that basis. In Canada, a recent tribunal ruling fixed certain rates and other requirements that are applicable to our Canadian digital music services. However, there is still some uncertainty with respect to the mechanics of its implementation, the result of which may hinder our ability to operate in Canada. In addition to certain other negotiations, European Union tribunals and/or negotiations are currently in process, which will set rates for subscription music services and services that deliver digital downloads of music, and the outcome of these negotiations and proceedings will also likely affect our business in ways that we cannot predict. Napster accrues for the cost of these fees, based on contracted or statutory rates, when established, or managements best estimates based on facts and circumstances regarding the specific music services and agreements in similar geographies or with similar agencies. If the final agreed rates differ significantly from managements estimate, the actual amount paid and expensed could differ materially from the recorded amounts. The differing types and large quantity of licenses that we must obtain creates significant complexities for our business and, as the licensing situation evolves in the different countries in which we operate, these requirements may significantly impact or hinder our ability to execute our business plans.
Our success depends on our digital music distribution services interoperability with our customers music playback hardware.
In order for the paid Napster service to be successful, we must design our service to interoperate effectively with a variety of hardware products, including PCs, portable MP3 players, music-enabled cell phones and other mobile devices, home stereos and car stereos. We depend on significant cooperation with manufacturers of these products and with software manufacturers that create the operating systems for such hardware devices to achieve our design objectives and to offer a service that is attractive to our customers. Currently, there are a limited number of devices that offer the portable subscription functionality that is required to support our Napster To Go and Napster Mobile services and certain current manufacturers may not be able to profitably continue to offer existing devices. Our software is not currently compatible with the Apple lines of products, which include the iPod music player, the current equipment market leader, and the iPhone. If we cannot successfully design our service to interoperate with the music playback devices that our customers own, or if music-enabled devices fail to grow significantly over time, our business will be harmed.
We may not successfully develop new products and services.
The success of our digital music distribution services will depend on our ability to develop leading-edge media and digital distribution products and services. Our business and operating results will be harmed if we fail to develop products and services that achieve widespread market acceptance or that fail to generate significant revenues or gross profits to offset our development and operating costs. We may not timely and successfully identify, develop and market new product and service opportunities.
Additionally, we may not be able to add new content such as video, spoken word or other content as quickly or as efficiently as our competitors or at all. If we introduce new products and services, they may not attain broad market acceptance or contribute meaningfully to our revenues or profitability. Competitive or technological developments may require us to make substantial, unanticipated investments in new products and technologies, and we may not have sufficient resources to make these investments.
Because the markets for our products and services are changing rapidly, we must develop new offerings quickly. Delays and cost overruns could affect our ability to respond to technological changes, evolving industry standards, competitive developments or customer requirements. Our products also may contain undetected errors that could cause increased development costs, loss of revenues, adverse publicity, reduced market acceptance of our products or services or lawsuits by customers.
We must maintain and add to our strategic marketing relationships in order to be successful.
We depend on a number of strategic relationships with third parties to co-market our services. We have entered into co-marketing agreements with infrastructure providers, mobile carriers, retailers, hardware manufacturers and other companies to broaden the distribution of our brand and our services. There is no guarantee that we will be able to renew existing agreements or enter into new agreements on acceptable terms, or at all. If we cannot maintain existing strategic relationships or enter into new relationships, our ability to market our services will be harmed.
In addition, because of the rapidly evolving nature of digital music distribution and our short history of operations, we often enter into strategic agreements where the financial impact on our business and operations is uncertain. We cannot guarantee that any of these agreements will result in the desired benefits to our business or result in significant additional revenue.
Our network is subject to security and stability risks that could harm our business and reputation and expose us to litigation or liability.
Online and mobile commerce and communications depend on the ability to transmit confidential information and licensed intellectual property securely over private and public networks. Any compromise of our ability to transmit such information and data securely or reliably, and any costs associated with preventing or eliminating such problems, could harm our business. Online transmissions are subject to a number of security and stability risks, including:
The occurrence of any of these or similar events could damage our business, hurt our ability to distribute products and services and collect revenue, threaten the proprietary or confidential nature of our technology, harm our reputation and expose us to litigation or liability. We may be required to expend significant capital or other resources to protect against the threat of security breaches, hacker attacks or system malfunctions or to alleviate problems caused by such breaches, attacks or failures.
We depend on key personnel who may not continue to work for us.
Our success substantially depends on the continued employment of certain executive officers and key employees, including, in particular, Christopher Gorog, our Chief Executive Officer. The loss of his services could harm our business. If Mr. Gorog were to leave our company, we could face substantial difficulty in hiring a qualified successor and could experience a loss in productivity while any such successor obtains the necessary training and experience.
If we fail to manage expansion effectively, we may not be able to successfully manage our business, which could cause us to fail to meet our customer demand or to attract new customers, which would adversely affect our revenue.
Our ability to successfully offer our products and services and implement our business plan in a rapidly evolving market requires an effective planning and management process. We plan to continue to increase the scope of our digital music distribution operations domestically and internationally. This anticipated growth in future operations may place a significant strain on our management resources that could distract managements attention and result in our failure to execute our business plan.
We may be unable to adequately protect our proprietary rights.
Our inability to protect our proprietary rights, and the costs of failing to do so, could harm our business. Our success and ability to compete partly depend on the superiority, uniqueness or value of our technology, including both internally developed technology and technology licensed from third parties. To protect our proprietary rights, we rely on a combination of patent, trademark, copyright and trade secret laws, confidentiality agreements with our employees and third parties, and protective contractual provisions. These efforts to protect our intellectual property rights may not be effective in preventing misappropriation of our technology. These efforts also may not prevent the development and design by others of products or technologies similar to, competitive with or superior to those we develop. Any of these results could reduce the value of our intellectual property. We may be forced to litigate to enforce or defend our intellectual property rights and to protect our trade secrets. Any such litigation could be very costly and could distract our management from focusing on operating our business.
A significant portion of the revenues from our digital music distribution business is derived from international revenues. Economic, political, regulatory and other risks associated with international revenues and operations could have an adverse effect on our revenues.
Because we operate in North America, Japan and Europe, our business is subject to risks associated with doing business internationally. Revenues from international operations have represented a significant portion of our total net revenues from our digital music distribution business. We anticipate that revenues from international operations will continue to represent a substantial portion of our total net revenues as we expand our Napster and Napster Mobile services abroad and enter into additional joint venture arrangements and other strategic partnerships, if any, with international partners. Accordingly, our future revenues could decrease based on a variety of factors, including:
To grow our business, we must be able to hire and retain sufficient qualified technical, sales, marketing and administrative personnel.
Our future success depends in part on our ability to attract and retain engineering, sales, marketing, finance and customer support personnel. If we fail to retain and hire a sufficient number of these employees, we will not be able to maintain and expand our business. We cannot assure you that we will be able to hire and retain a sufficient number of qualified personnel to meet our business objectives.
We may be subject to intellectual property infringement claims, which are costly to defend and could limit our ability to use certain technologies in the future.
Many parties are actively developing streaming media and digital distribution-related technologies, e-commerce and other web-related technologies, as well as a variety of online business methods and models. We believe that these parties will continue to take steps to protect these technologies, including, but not limited to, seeking patent protection. As a result, disputes regarding the ownership of these technologies and rights associated with streaming media, digital distribution and online businesses are likely to arise in the future and may be very costly. In addition to existing patents and intellectual property rights, we anticipate that additional third-party patents related to our products and services will be issued in the future. If a blocking patent has been issued or is issued in the future, we would need to either obtain a license or design around the patent. We may not be able to obtain such a license on acceptable terms, if at all, or design around the patent, which could harm our business.
Companies in the technology and content-related industries have frequently been subjected to litigation regarding intellectual property rights. In addition, we believe these industries are experiencing an increased level of litigation to determine the applicability of current laws to, and the impact of new technologies on, the use and distribution of content over the Internet and through new devices, especially in the music industry. From time to time, we receive claims and inquiries from third parties alleging that our internally developed technology, or technology we license from third parties, may infringe their proprietary rights, especially patents. Third parties have also asserted and most likely will continue to assert claims against us alleging infringement of copyrights, trademark rights, or other proprietary rights, or alleging unfair competition or violations of privacy rights. As we continue to develop and introduce products and services that provide or enable the provision of content, our litigation risk may increase. As a result, we could be required to spend significant amounts of time and money to defend ourselves against such claims. If any of these claims were to prevail, we could be forced to pay damages, comply with injunctions, or stop distributing our products and services while we re-engineer them or seek licenses to necessary technology, which might not be available on reasonable terms, or at all. We could also be subject to claims for indemnification resulting from infringement claims made against our customers and strategic partners, which could increase our defense costs and potential damages. Any of these events could require us to change our business practices and could harm our business.
A decline in current levels of consumer spending could reduce our sales.
Our business is directly affected by the level of consumer spending. One of the primary factors that affects consumer spending is the general state of the local economies in which we operate. Lower levels of consumer spending in regions in which we have significant operations could have a negative impact on our business, financial condition or results of operations.
We may need additional capital, and we cannot be sure that additional financing will be available.
Although we currently anticipate that our available funds and expected cash flows from operations will be sufficient to meet our cash needs for at least the next twelve months, we may require additional financing. Our ability to obtain financing will depend, among other things, on our development efforts, business plans, operating performance and condition of the capital markets at the time we seek financing. We expect to experience operating losses from the digital music distribution business in at least the short-term. We cannot assure you that additional financing will be available to us on favorable terms when required, or at all. If we raise additional funds through the issuance of equity, equity-linked or debt securities, those securities may have rights, preferences or privileges senior to the rights of our common stock, and our stockholders may experience dilution.
We are subject to risks associated with governmental regulation and legal uncertainties.
Few existing laws or regulations specifically apply to the Internet, other than laws and regulations generally applicable to businesses. Certain United States export controls and import controls of other countries, including controls on the use of encryption technologies, may apply to our products. Many laws and regulations, however, are pending and may be adopted in the United States, individual states, and local jurisdictions and other countries with respect to the Internet. In addition, as we conduct more business via mobile platforms in multiple countries, our business will likely be impacted by additional laws and regulations that are applicable to the mobile space. These laws may relate to many areas that impact our business, including content issues (such as obscenity, indecency and defamation), copyright and other intellectual property rights, digital rights management, encryption, caching of content by server products, personal privacy, taxation, e-mail, sweepstakes, promotions, prepaid card expiration, escheatment, network and information security and the convergence of traditional communication services with Internet communications, including the future availability of broadband transmission capability and wireless networks. These types of regulations are likely to differ between countries and other political and geographic divisions. Other countries and political organizations are likely to impose or favor more and/or different regulations than that which has been proposed in the United States, thus furthering the complexity of regulation. In addition, state and local governments may impose regulations in addition to, inconsistent with, or stricter than federal regulations. The adoption of such laws or regulations, and uncertainties associated with their validity, interpretation, applicability and enforcement, may affect the available distribution channels for and costs associated with our products and services and may affect the growth of the Internet. Such laws or regulations may harm our business. Our products and services may also become subject to investigation and regulation of foreign data protection and e-commerce authorities, including those in the European Union. Such activities could result in additional product and distribution costs for us in order to comply with such regulations.
We do not know for certain how existing laws governing issues such as property ownership, copyright and other intellectual property issues, digital rights management, taxation, security, illegal or obscene content, retransmission of media, personal privacy and data protection apply to the Internet. The vast majority of such laws were adopted before the advent of the Internet and related technologies and do not address the unique issues associated with the Internet and related technologies. Most of the laws that relate to the Internet have not yet been interpreted. In addition to potential legislation from local, state and federal governments, labor guild agreements and other laws and regulations that impose fees, royalties or unanticipated payments regarding the distribution of media over the Internet may directly or indirectly affect our business. While we and our customers may be directly affected by such agreements, we are not a party to such agreements and have little ability to influence the degree to which such agreements favor or disfavor Internet distribution or our business models. Changes to or the interpretation of these laws and the entry into such industry agreements could:
The Child Online Protection Act and the Child Online Privacy Protection Act impose civil and criminal penalties on persons distributing material harmful to minors (e.g., obscene material) over the Internet to persons under the age of 17, or collecting personal information from children under the age of 13. We do not knowingly distribute harmful materials to minors or collect personal information from children under the age of 13. The manner in which these Acts may be interpreted and enforced cannot be fully determined, and future legislation similar to these Acts could subject us to potential liability if we were deemed to be non-compliant with such rules and regulations, which in turn could harm our business.
There are a large number of legislative proposals before the United States Congress and various state legislatures regarding intellectual property, digital rights management, copy protection requirements, privacy, email marketing and security issues related to our business. Furthermore, as part of our regular business activities now, and in the past, we engage in the issuance of gift cards redeemable for our services. It is possible that money received by us for the sale of gift cards could be subject to state and federal escheatment, or unclaimed property, laws in the future. If this were the case, our business could be adversely impacted. It is not possible to predict whether or when such legislation may be adopted, and certain proposals, if adopted, could materially and adversely affect our business through a decrease in user registration and revenue, and influence how and whether we can communicate with our customers.
We may be subject to assessment of additional sales and other taxes for the sale of our products, license of technology or provision of services.
We do not currently collect sales or other taxes on the sale of our products, license of technology or provision of services in states and countries other than those in which we have offices or employees. Our business would be harmed if one or more states or any foreign country were to require us to collect sales or other taxes from past sales or income related to products, licenses of technology or provision of services.
We may be subject to market risk and legal liability in connection with the data collection capabilities of our products and services.
If, in the future, we conclude that our internal control over financial reporting is not effective, or if our auditors conclude that our internal control over financial reporting is not effective, investors could lose confidence in the reliability of our financial statements, which could result in a decrease in the value of our common stock.
As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission (SEC) adopted rules requiring public companies to include a report of management on the companys internal control over financial reporting in their annual reports on Form 10-K. This report is required to contain an assessment by management of the effectiveness of such companys internal control over financial reporting. In addition, the independent registered public accounting firm auditing a public companys financial statements must attest to the effectiveness of the companys internal control over financial reporting. There is a risk that in the future we may identify internal control deficiencies that suggest that our controls are no longer effective. This could result in an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements, which could cause the market price of our common stock to decline and make it more difficult for us to finance our operations.
The effectiveness of our disclosure and internal controls may be limited.
Our disclosure controls and procedures and internal control over financial reporting may not prevent all errors and misrepresentations. In the event that there are errors or misrepresentations in our historical financial statements or the SEC disagrees with our accounting, we may need to restate our financial statements. For example, in November 2004 we restated our financial statements in order to correct the valuation of a previously issued warrant and to adjust the purchase accounting of our former subsidiary, MGI Software, and in May 2005 we restated our financial statements to reallocate the tax benefit of certain operating losses from our discontinued operations to our continuing operations. Any system of internal controls can only provide reasonable assurance that all control objectives are met. Some of the potential risks involved could include, but are not limited to, management judgments, simple errors or mistakes, willful misconduct regarding controls or misinterpretation. There is no guarantee that existing controls will prevent or detect all material issues or be effective in future conditions, which could materially and adversely impact our financial results in the future.
Provisions in our agreements, charter documents, stockholder rights plan and Delaware law may delay or prevent acquisition of us, which could decrease the value of our stock.
Our certificate of incorporation and bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us without the consent of our board of directors. These provisions include a classified board of directors and limitations on actions by our stockholders by written consent. In addition, our board of directors has the right to issue preferred stock without stockholder approval, which could be used to dilute the stock ownership of a potential hostile acquirer. Delaware law also imposes some restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding common stock. In addition, we have adopted a stockholder rights plan that makes it more difficult for a third party to acquire us without the approval of our board of directors. Although we believe these provisions provide for an opportunity to receive a higher bid by requiring potential acquirers to negotiate with our board of directors, these provisions apply even if the offer may be considered beneficial by some stockholders.
(c) In accordance with the terms applicable to restricted stock awards to our employees, we require our employees to deliver shares of our common stock to us in order to satisfy any applicable tax withholding requirements that arise in connection with the vesting of their restricted stock awards. During the three months ended December 31, 2007, our employees delivered 20,427 shares of our common stock to us to satisfy tax-withholding obligations with respect to restricted stock awards that vested during such period.
The exhibits listed on the Exhibit Index (following the Signatures section of this report) are included, or incorporated by reference, in this Quarterly Report.
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned thereunto duly authorized.
INDEX TO EXHIBITS