Further down the list of low EV/Assets companies of the Pacific Northwest, we find an interesting looking name heretofore unstudied by most respectable value investors, software player RealNetworks Inc of Seattle.
Back in the glory days of March 2000, a Robertson Stephens analyst who shall remain nameless, gushed in a buy recommendation that RealNetworks and its software was an “essential” component of media’s digital revolution. With the benefit of hindsight we judge this sentiment as somewhat excessive. Instead of being essential to the media’s internet revolution, this company has been more of a bystander to the superior efforts of Apple (owner of iTunes) and Google (owner of You Tube). Rather than blossom into the next Microsoft, RealNetworks for the past decade has been the software industry’s version of onetime Beatles drummer Pete Best – there at the beginning, but unable to enjoy the fruits of lasting success.
However, with the bubble era safely behind us, and a number of factors looking much more promising now than they did then, the time may finally have arrived for investors to get excited about RealNetworks.
Figure 1: The Beatles with Pete Best on Drums (Ringo Comes Later)
Founded in 1995 by former Bill Gates protégé Rob Glaser, RealNetworks was one of the pioneers of internet media downloads. The company’s early programs such as Real Audio and Real Player, distributed free with open-source software, helped to establish the ubiquitous file sharing of music and audio-visual internet content.
RealNetworks was a quintessential bubble stock. Glaser, who was already a millionaire many times over by the time he left Microsoft, reached a paper net worth of over US$5 Billion at the mania’s peak. Softened up by Wall Street enthusiasm, investors flocked to RNWK, which traded over 100X revenue and 30X book in 1999.
As we now know, the promoters of the turn of the century got only half the story right. Yes, the way we access music and video has been revolutionized by downloads from the internet. And, yes the internet has allowed for a much more decentralized and creative world than the one where audio-visual distribution was controlled by owners of broadcast licenses. However, the dreamed-of profits of RealNetworks and many of its competitors never materialized. The oversupply of capital to this industry, as it has in so many other industries over the years, led to a prolonged period of very low returns.
Figure 2. RealNetworks share price 1998-2009
The company, as it now operates, has a revenue run-rate of over US$500M. It earns its revenue from selling music on its Rhapsody online store, from advertising on music and gaming sites, and from selling premium download software and related services to corporations. A significant corporate customer group includes mobile phone carriers such as Verizon and SK Telecom, where RealNetworks also markets ringtones.
Despite having reached such a size, and consistently running gross margins over 60%, RealNetworks has rarely been profitable. The causes of the troubles are not entirely clear. Either it is unable to reach critical scale in its many disparate business units, or it is unable to keep overheads at a reasonable level. Even the company’s 2005 heyday, when free cash flow reached $446 Million, was a bit of an asterisk -- coming entirely on the back of a $761 Million antitrust suit settlement from Microsoft.
Investment Thesis
What on earth is the attraction of such a long-term underperformer? I believe it comes down to three elements: cash, fatigue and hope. The cash part is fairly easy to quantify. At the most recent quarter RealNetworks reported net cash balances of $376 Million, slightly more than yesterday’s market capitalization of $342 Million (or $2.55 per share). The cash is subject to a $218M put option which relates to its prior acquisition of MTV’s online music store, although this amount can be offset through purchases of advertising on MTV. Assume that the MTV put ultimately costs RealNetworks $100M over fair value and one still has a net cash value of $276 Million or 80% of market cap.
The second element appears to be fatigue on the part of management with the company’s underperformance. A recent initiative to spin-off the games business, as opposed to acquiring in that area to build scale, may be a sign of a new resolve to generate value at RealNetworks. When the CEO’s equity stake is worth $5 Billion, every new Chinese wireless deal is worth studying. Now that Glaser’s stake has been reduced to the near chump change of $130 Million, pencils appear to be sharpening at HQ. The fact that the games spin-off got pulled due to weak equity markets was probably less important than its approval in the first place. It is a sign that every value creation alternative is on the table and being evaluated keenly.
The hope for RealNetworks lies in its September 2008 launch of Real DVD, a software program that allows individuals to copy DVD’s on their home computer. It promises to do for movies what the mp3 file did for music. Not surprisingly, this launch is subject to a legal challenge by the major Hollywood studios. While history is probably on the side of Real Networks, it is unclear how a judge might decide the case in the near term. There are two potential positive outcomes for Glaser and company. It is possible that the courts permit the company to market the product, which would be a huge but unquantifiable plus. The second potential win for RNWK is that they can eventually make an anti-trust case stick against the studios, and profit through a Microsoft-style legal settlement as opposed to actual business activities. This is America, after all.
Risks
No investment is without risks, as longtime RealNetworks shareholders understand completely. Competition in media and software business remains brutal. With a 38% stake, CEO Rob Glaser has the power to drive the company off a cliff with a reckless acquisition. The recession could deepen and monies invested in wireless applications and enterprise software initiatives could be wasted on markets that have turned out again to be too small. However, there aren’t many public companies with revenues and gross margin dollars almost twice what they were ten years ago that trade for less than net cash. The risks highlighted above appear to be worth taking.
Summary and Target
Software valuations are very tricky, and estimating a break-up value for Real Networks would probably keep a team of investment bankers going for a week. At a very top level, one might expect even a weak business to attract a revenue multiple between 0.5 and 1.0 times, assuming the business were acquired by a trade player. On the current run-rate of $560 Million in revenue, that might equate to $420 Million in Enterprise Value.
Figure 3. RealNetworks Valuation Estimate
|
|
$US Million |
$US per share |
|
Net Cash |
376 |
2.69 |
|
MTV put for Rhapsody JV |
(100) |
(0.70) |
|
Break-up value |
420 |
3.00 |
|
Total |
696 |
4.97 |
Putting it all together, one comes up with an asset value for RealNetworks in the $700 Million range, which is roughly $5 per share or twice the prevailing market value. A 38% owner like Glaser, were he convinced of the merits of the valuation, could probably still pull off a levered take-private transaction in this market. Conversely, a move by Glaser to exit and sell off the parts could also generate that value.
Upside exists in spades beyond this level, if the promises of Rhapsody and Real DVD come to fruition, along with other corporate plans. However, a 100% return from the current market of $2.55 per share is nothing to sneeze at, and so I would buy with a limit sell at $5.
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