10-Q 1 d10q.htm FORM 10-Q Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-Q

 


(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2006

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934

Commission File Number: 000-32373

 


Napster, Inc.

(Exact name of Registrant as specified in its charter)


 

Delaware   77-0551214

(State or other jurisdiction of

incorporation or organization)

 

(IRS Employer

Identification No.)

9044 Melrose Avenue

Los Angeles, California 90069

(Address of principal executive offices, including zip code)

Registrant’s 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):

 

Large accelerated filer  ¨   Accelerated filer  x   Non-accelerated filer  ¨

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 July 27, 2006, there were 44,833,720 shares of the Registrant’s Common Stock outstanding, par value $0.001.

 



Table of Contents

NAPSTER, INC.

TABLE OF CONTENTS

 

               Page
Number
PART I.    Financial Information    1
   Item 1    Financial Statements (unaudited)    1
      Condensed Consolidated Balance Sheets as of June 30, 2006 and March 31, 2006    1
      Condensed Consolidated Statements of Operations for the three months ended June 30, 2006 and 2005    2
      Condensed Consolidated Statement of Changes in Stockholders’ Equity for the three months ended June 30, 2006    3
      Condensed Consolidated Statements of Cash Flows for the three months ended June 30, 2006 and 2005    4
      Notes to Condensed Consolidated Financial Statements    6
   Item 2    Management’s Discussion and Analysis of Financial Condition and Results of Operations    15
   Item 3    Quantitative and Qualitative Disclosures about Market Risk    27
   Item 4    Controls and Procedures    28
PART II    Other Information    29
   Item 1    Legal Proceedings    29
   Item 1A    Risk Factors    29
   Item 2    Unregistered Sales of Equity Securities and Use of Proceeds    44
   Item 3    Defaults Upon Senior Securities    44
   Item 4    Submission of Matters to a Vote of Security Holders    44
   Item 5    Other Information    44
   Item 6    Exhibits    44
Signatures    45
Index to Exhibits    46
Exhibit 31.1   
Exhibit 31.2   
Exhibit 32.1   

 

i


Table of Contents

Cautionary Note regarding Forward-Looking Statements

In addition to historical information, this Quarterly Report on Form 10-Q (this “Quarterly Report”) contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are those that predict or describe future events or trends and that do not relate solely to historical matters. You can generally identify forward-looking statements as statements containing the words “believe,” “expect,” “will,” “anticipate,” “intend,” “estimate,” “project,” “plan,” “may,” “predict,” “assume” or other similar expressions, although not all forward-looking statements contain these identifying words. All statements in this Quarterly Report regarding our future strategy, future operations, projected financial position, estimated future revenues, projected costs, future prospects, and results that might be obtained by pursuing management’s current plans and objectives are forward-looking statements. You should not place undue reliance on our forward-looking statements because the matters they describe are subject to known and unknown risks, uncertainties and other unpredictable factors, many of which are beyond our control. Our forward-looking statements are based on the information currently available to us and speak only as of the date on which this Quarterly Report was filed with the Securities and Exchange Commission (“SEC”). We expressly disclaim any obligation to issue any updates or revisions to our forward-looking statements, even if subsequent events cause our expectations to change regarding the matters discussed in those statements. Over time, our actual results, performance or achievements will likely differ from the anticipated results, performance or achievements that are expressed or implied by our forward-looking statements, and such difference might be significant and materially adverse to our stockholders. Many important factors that could cause such a difference are described in this Quarterly Report under the caption “Risk Factors” which you should review carefully. Please consider our forward-looking statements in light of those risks as you read this Quarterly Report.

 

ii


Table of Contents

PART I - FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

NAPSTER, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

(unaudited)

 

     As of  
     June 30,
2006
    March 31,
2006
 
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 42,658     $ 46,812  

Short-term investments

     55,169       49,812  

Foreign currency conversion in transit

           7,545  

Accounts receivable, net of allowance for doubtful accounts of $8 at June 30, 2006 and $7 at March 31, 2006

     1,101       1,042  

Prepaid expenses and other current assets

     3,559       6,182  
                

Total current assets

     102,487       111,393  

Property and equipment, net

     6,472       7,012  

Goodwill

     34,658       34,658  

Investment in unconsolidated entity

     1,826       2,203  

Other assets

     247       275  
                

Total assets

   $ 145,690     $ 155,541  
                
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Current liabilities:

    

Accounts payable

   $ 3,056     $ 3,279  

Income taxes payable

     4,146       4,139  

Accrued liabilities

     18,178       16,745  

Deferred revenues

     10,523       12,824  
                

Total current liabilities

     35,903       36,987  

Long-term liabilities

    

Deferred income taxes

     2,854       2,622  

Other long-term liabilities

     140       159  
                

Total liabilities

     38,897       39,768  
                

Commitments and contingencies (Note 8)

    

Stockholders’ equity:

    

Common stock, $0.001 par value; Authorized: 100,000 shares; Issued: 44,886 shares at June 30, 2006 and 43,826 shares at March 31, 2006

     45       44  

Additional paid-in capital

     258,132       260,198  

Deferred stock-based compensation

           (2,934 )

Accumulated deficit

     (151,186 )     (141,368 )

Accumulated other comprehensive loss

     (198 )     (167 )
                

Total stockholders’ equity

     106,793       115,773  
                

Total liabilities and stockholders’ equity

   $ 145,690     $ 155,541  
                

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

1


Table of Contents

NAPSTER, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

 

    

Three Months Ended

June 30,

 
     2006     2005  

Net revenues

   $ 28,116     $ 21,001  

Cost of revenues (1)

     19,122       14,405  
                

Gross margin

     8,994       6,596  

Operating expenses:

    

Research and development (1)

     2,937       3,195  

Sales and marketing (1)

     10,471       16,272  

General and administrative (1)

     5,988       6,196  

Amortization of intangible assets

           474  
                

Total operating expenses

     19,396       26,137  
                

Loss from operations

     (10,402 )     (19,541 )

Loss from unconsolidated entity

     (330 )      

Other income (expense), net

     1,181       (120 )
                

Loss before income tax provision

     (9,551 )     (19,661 )

Income tax provision

     (267 )     (265 )
                

Net loss

   $ (9,818 )   $ (19,926 )
                

Basic and diluted net loss per share

   $ (0.23 )   $ (0.46 )
                

Weighted average shares used in computing net loss per share

    

Basic and diluted

     43,097       42,961  
                

__________          

(1)    Amounts reported include stock-based compensation expense as follows:

    

Cost of revenues

   $ 10     $ 1  

Research and development

     187       23  

Sales and marketing

     143       9  

General and administrative

     634       96  

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

2


Table of Contents

NAPSTER, INC.

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN

STOCKHOLDERS’ EQUITY

(in thousands)

(unaudited)

 

    Common Stock  

Additional
Paid-in
Capital

   

Deferred
Stock-based
Compensation

   

Accumulated
Deficit

   

Accumulated
Other
Comprehensive
Loss

   

Total
Stockholders’
Equity

 
    Shares
Outstanding
    Amount          

Balance at March 31, 2006

  43,826     $ 44   $ 260,198     $ (2,934 )   $ (141,368 )   $ (167 )   $ 115,773  

Net loss

                        (9,818 )           (9,818 )

Foreign currency translation adjustment

                              (5 )     (5 )

Unrealized loss, net on short- term investments

                              (26 )     (26 )
                   

Total comprehensive loss

                (9,849 )

Reversal of deferred stock- based compensation upon adoption of SFAS No. 123(R)

            (2,934 )     2,934                    

Issuance of common stock under employee stock plans, net of cancelations

  1,060       1     92                         93  

Cost of shares repurchased

  (60 )         (198 )                       (198 )

Stock-based compensation expense

            974                         974  
                                                   

Balance at June 30, 2006

  44,826     $ 45   $ 258,132     $     $ (151,186 )   $ (198 )   $ 106,793  
                                                   

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

3


Table of Contents

NAPSTER, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

     Three Months Ended June 30,  
     2006     2005  

Cash flows from operating activities:

    

Net loss

   $ (9,818 )   $ (19,926 )

Adjustments to reconcile net loss to net cash used in operating activities:

    

Depreciation and amortization

     938       1,310  

Amortization of prepaid marketing expenses

           1,038  

Stock-based compensation charges

     974       129  

Change in fair market value of investment hedge

           342  

Non-cash loss from remeasurement of cash balance

           501  

Deferred tax expense

     232       232  

Loss from unconsolidated entity

     330        

Change in operating assets and liabilities:

    

Accounts receivable

     (57 )     197  

Prepaid expenses and other current and long term assets

     472       1,227  

Accounts payable

     (241 )     227  

Income taxes payable

     4       (324 )

Accrued liabilities

     1,434       442  

Deferred revenues

     (2,302 )     (749 )

Other long-term liabilities

     (17 )     3  
                

Net cash used in operating activities

     (8,051 )     (15,351 )
                

Cash flows from investing activities:

    

Purchases of property and equipment

     (397 )     (296 )

Proceeds from sale of Consumer Software Division

     2,200        

Purchases of short-term investments

     (26,192 )     (17,141 )

Proceeds from maturities and sale of short-term investments

     20,809       1,714  

Foreign currency conversion in transit

     7,545        
                

Net cash provided by (used in) investing activities

     3,965       (15,723 )
                

Cash flows from financing activities:

    

Principal payment of capital lease obligation

     (30 )     (27 )

Repayment of line of credit

           (15,000 )

Issuance of common stock under employee stock plans

     93        

Repurchase of common stock

     (198 )      
                

Net cash used in financing activities

     (135 )     (15,027 )
                

Effect of exchange rates on cash

     67       (682 )

Change in cash and cash equivalents

     (4,154 )     (46,783 )

Cash and cash equivalents at beginning of period

     46,812       135,416  
                

Cash and cash equivalents at end of period

   $ 42,658     $ 88,633  
                

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

4


Table of Contents

NAPSTER, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS—(Continued)

(in thousands)

(unaudited)

 

     Three Months Ended June 30,
     2006     2005

Non-cash disclosure of investing and financing activities:

    

Unrealized gains (losses) on short term investments, net

   $ (26 )   $ 29
              

Deferred stock-based compensation related to issuance of common stock options and restricted awards to employees, net of terminations

   $     $ 3,609
              

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

5


Table of Contents

NAPSTER, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 1—BASIS 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, 2006, 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 Napster’s Annual Report on Form 10-K for the year ended March 31, 2006.

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

Advertising costs are expensed as incurred through direct spending and were approximately $6.9 million and $13.1 million for the three months ended June 30, 2006 and 2005, respectively.

Revenue Recognition

We recognize revenues in accordance with Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition in Financial Statements”, Emerging Issues Task Force (“EITF”) 00-21, “Revenue Arrangements with Multiple Deliverables”, and EITF 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent”. In general, we recognize revenue, net of sales related taxes, when there is persuasive evidence of an arrangement, the fee is fixed or determinable, the product or services have been delivered and collectibility of the resulting receivable is reasonably assured.

 

6


Table of Contents

Revenues from prepaid cards and promotions are deferred and then recognized as (i) tracks are downloaded by the end users, (ii) if redeemed for a subscription, over the subscription period or (iii) when Napster has no further obligation to provide services or refund the associated prepayments (“prepaid card breakage”). As of June 30, 2006, we have not had sufficient historical experience to estimate prepaid card breakage rates, so we recognize prepaid card breakage when our obligation to honor the redemption of the prepaid cards or promotions has legally expired. During the first quarter of fiscal 2007, based on the resolution of certain legal restrictions associated with previously sold prepaid cards, we recognized $2.2 million of prepaid card breakage, of which $1.9 million relates to cards that were subject to expiration based on their term prior to 2007 but had other legal restrictions that precluded our recognition of revenue. The remaining $300,000 was related to cards that expired during the first quarter of fiscal 2007.

During May 2006 we launched a free music service on which we sell advertising. Advertising revenues are recognized when an advertisement appears in web pages viewed by users. Advertising revenues were immaterial during the first quarter of fiscal 2007.

NOTE 2—CASH, CASH EQUIVALENTS AND INVESTMENTS

Cash and Cash Equivalents

Napster’s cash and cash equivalents at fair value consist of the following (in thousands):

 

    

June 30,

2006

  

March 31,

2006

Cash

   $ 17,654    $ 6,359
             

Cash equivalents:

     

Commercial paper

     21,588      22,773

Certificates of deposit

     906      1,106

Money market securities

     2,510      16,574
             

Total cash equivalents

     25,004      40,453
             

Total cash and cash equivalents

   $ 42,658    $ 46,812
             

Short-Term Investments

Napster’s short-term investments at fair value consist of the following (in thousands):

 

    

June 30,

2006

  

March 31,

2006

Commercial paper

   $ 9,112    $ 5,041

Asset backed

     5,124     

Certificates of deposit

     2,121      3,979

Corporate securities

     30,194      25,399

Municipal securities

     3,001      9,815

U.S. agencies securities

     5,617      5,578
             
   $ 55,169    $ 49,812
             

 

7


Table of Contents

Napster’s 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.

Approximately $47.9 million and $47.0 million of the short-term investments mature in less than one year as of June 30, 2006 and March 31, 2006, respectively. The remaining short-term investments generally have effective maturity dates between one and two years. Because the short-term investments represent the investment of cash available to fund current operations, the entire balance has been classified as short-term in the balance sheet.

Realized gains and losses, amortization and accretion on cash equivalents and short-term investments, net, totaled $420,000 and $70,000 for the three months ended June 30, 2006 and 2005, respectively. Gross realized losses on short-term investments for the three months ended June 30, 2006 and 2005 were not significant. Additionally, gross unrealized gains on cash equivalents and short-term investments were $4,000 as of June 30, 2006 and March 31, 2006, and gross unrealized losses were $141,000 and $114,000 as of June 30, 2006 and March 31, 2006, respectively. Napster has determined that the gross unrealized losses on its available-for-sale securities as of June 30, 2006 are temporary in nature.

NOTE 3—BALANCE SHEET DETAIL

Deferred revenues (in thousands)

 

    

June 30,

2006

  

March 31,

2006

Unearned subscription revenue

   $ 4,569    $ 4,592

Unredeemed pre-paid card and promotional content

     4,726      6,929

Unearned hardware and license revenue

     1,001      1,012

Other

     227      291
             
   $ 10,523    $ 12,824
             

During the first quarter of fiscal 2007, based on the resolution of certain legal restrictions associated with previously sold prepaid cards, we recognized $2.2 million of prepaid card breakage, of which $1.9 million relates to cards that were subject to expiration based on their term prior to 2007 but had other legal restrictions that precluded our recognition of revenue. The remaining $300,000 was related to cards that expired during the first quarter of fiscal 2007.

NOTE 4—SHORT-TERM DEBT

At June 30, 2006, Napster had available a $17.0 million revolving line of credit with Silicon Valley Bank and was in compliance with all financial covenants relating to this line of credit. There was no balance outstanding under this line of credit at June 30, 2006.

 

8


Table of Contents

NOTE 5—STOCKHOLDERS’ EQUITY

Stock-based Compensation

Effective April 1, 2006, Napster adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”). SFAS No. 123(R) requires the measurement and recognition of compensation expense for all stock-based awards issued to employees and directors based on estimated fair values. SFAS No. 123(R) supersedes Napster’s previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), for periods beginning April 1, 2006. In March 2005, the SEC issued SAB No. 107 (“SAB 107”) relating to SFAS No. 123(R). Napster has applied the provisions of SAB 107 in its adoption of SFAS No. 123(R).

Napster adopted SFAS No. 123(R) using the modified prospective method, which requires the application of the accounting standard as of April 1, 2006, the first day of the Company’s fiscal year. Napster’s condensed consolidated financial statements as of and for the three-month period ended June 30, 2006 reflect the impact of SFAS No. 123(R). In accordance with the modified-prospective transition method, Napster’s condensed consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of adopting SFAS No. 123(R). Effective April 1, 2006, stock-based compensation expense includes compensation expense for (1) all stock-based compensation awards granted prior to but not vested as of April 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”), and (2) all stock-based compensation awards granted after April 1, 2006 based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R).

Under SFAS No. 123(R), compensation expense for all share-based compensation awards is recognized on a straight-line basis over the period the employee performs the related services, generally the vesting period of four years, net of estimated forfeitures. The application of the estimated forfeiture rate under SFAS No. 123(R) to unvested restricted stock awards as of April 1, 2006 was not material. Napster has estimated forfeitures based on historical experience and will revise the rates, if necessary, in subsequent periods if actual forfeitures differ from initial estimates.

The $974,000 of stock-based compensation expense during the first quarter of fiscal 2007 includes approximately $640,000 ($0.01 per share) related to stock options and shares purchased under the Employee Stock Purchase Plan (“ESPP”), which would not have been expensed under the intrinsic value method of APB No. 25.

Under SFAS No. 123(R), Napster has selected the Black-Scholes option-pricing model to determine the estimated fair value at the date of grant for stock options, which is consistent with the method Napster used for pro forma option disclosures under SFAS No. 123. The fair value of stock options granted for the three months ended June 30, 2006 was $72,000. The fair value of restricted stock awards is measured at the market price of the unrestricted stock on the grant date.

Prior to the adoption of SFAS No. 123(R), Napster presented deferred compensation as a separate component of stockholders’ equity. In accordance with the provisions of SFAS No. 123(R), on April 1, 2006, Napster reclassified the balance of deferred compensation expense to additional paid-in capital on its condensed consolidated balance sheet.

 

9


Table of Contents

The adoption of SFAS No. 123(R) also requires additional accounting related to income taxes. Due to the full valuation allowance provided on its net deferred tax assets, Napster has not recorded any tax benefit attributable to stock-based compensation expense.

The following table illustrates the effect on net loss and net loss per share for the three months ended June 30, 2005, if Napster had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation using the Black-Scholes model (in thousands, except per share amounts):

 

    

Three Months Ended

June 30, 2005

 

Net loss, as reported

   $ (19,926 )

Add:

  

Stock-based compensation expense included in reported net loss

     129  

Deduct:

  

Stock-based employee compensation expense determined under fair value method for all awards

     (1,237 )
        

Pro forma net loss

   $ (21,034 )
        

Net loss per share:

  

Basic and diluted—as reported

   $ (0.46 )

Basic and diluted—pro forma

   $ (0.49 )

Weighted average shares used in computing net income and pro forma net income per share:

  

Basic and diluted shares

     42,961  

Employee Stock Plans

The following table summarizes the activity relating to restricted stock awards and stock option grants for the three month period ended June 30, 2006:

 

     Restricted Stock    Stock Options
     Number
Unvested
    Weighted
Average
Fair Value
   Number
Outstanding
    Weighted
Average
Exercise Price

Balance at March 31, 2006

   784,810     $ 4.17    4,321,637     $ 7.52

Awarded/granted

   1,144,875     $ 4.04    26,700     $ 4.05

Vested

   (175,734 )   $ 4.21         

Exercised

            (22,032 )   $ 4.13

Forfeited

   (106,827 )   $ 4.06    (53,623 )   $ 4.30

Expired

            (157,026 )   $ 7.15
                 

Balance at June 30, 2006

   1,647,124     $ 4.08    4,115,656     $ 7.57
                 

As of June 30, 2006, there was $5.7 million, $3.2 million and $61,000 of total unrecognized compensation expense related to unvested restricted stock awards, stock options and ESPP purchases, respectively, which are expected to be recognized over the weighted-average periods of 2.18, 1.02 and 0.77 years, respectively.

 

10


Table of Contents

The following table summarizes information about stock options outstanding as of June 30, 2006:

 

     Options Outstanding    Options Exercisable

Range of

Exercise Prices

   Number
Outstanding
  

Weighted
Average
Remaining
Contractual Life

(in years)

   Weighted
Average
Exercise Price
   Number
Exercisable
  

Weighted
Average
Remaining
Contractual Life

(in years)

   Weighted
Average
Exercise
Price

$3.48–$4.09

   537,592    6.21    $ 3.88    466,304       $ 3.88

$4.13

   1,089,094    8.10    $ 4.13    479,490       $ 4.13

$4.23–$7.22

   265,219    7.55    $ 4.91    154,239       $ 4.96

$7.47

   654,438    7.19    $ 7.47    451,879       $ 7.47

$7.78–$8.37

   93,063    8.51    $ 8.12    32,047       $ 8.13

$8.50

   654,500    4.80    $ 8.50    654,500       $ 8.50

$8.84–$16.55

   821,750    5.50    $ 14.68    785,610       $ 14.93
                     
   4,115,656    6.64    $ 7.57    3,024,069    6.23    $ 8.43
                     

Because there were no in-the-money options outstanding at June 30, 2006, the aggregate intrinsic value applicable to options included in the above table was zero.

As of June 30, 2006, Napster has reserved shares of common stock for future issuance as follows:

 

Stock option and award plans

   11,173,734

ESPP

   457,216
    
   11,630,950
    

NOTE 6—EARNINGS PER SHARE

Basic net loss per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net loss per share is computed using the weighted-average number of common and dilutive common equivalent shares outstanding during the period. Potentially dilutive common equivalent shares consist of restricted stock awards that are subject to repurchase and common stock issuable upon exercise of stock options, computed using the treasury stock method.

Common equivalent shares excluded from the calculation because their effect would have been anti-dilutive totaled 5.8 million and 5.9 million for the three months ended June 30, 2006 and 2005, respectively.

 

11


Table of Contents

NOTE 7—GEOGRAPHIC INFORMATION

Net Revenue

The following table presents net revenues by country based on the location of customers (in thousands):

 

    

Three Months Ended

June 30,

     2006    2005

United States

   $ 24,240    $ 18,475

United Kingdom

     2,969      2,526

Germany

     907     
             
   $ 28,116    $ 21,001
             

Cash and Investments

The following table presents cash, cash equivalents, foreign currency conversion in transit and short-term investments by the country where the funds were held (in thousands):

 

    

June 30,

2006

  

March 31,

2006

United States

   $ 85,729    $ 93,948

United Kingdom

     1,113      1,837

Denmark

     7,625      7,545

Luxembourg

     3,167      839

Germany

     193     
             
   $ 97,827    $ 104,169
             

Napster does not anticipate that it will incur any material U.S. income or foreign withholding taxes when cash is repatriated to the United States.

Long-Lived Assets

The following table presents long-lived assets, excluding goodwill and investment in unconsolidated entity, by country based on the location of the assets (in thousands):

 

    

June 30,

2006

  

March 31,

2006

United States

   $ 6,680    $ 7,201

Other

     39      86
             
   $ 6,719    $ 7,287
             

 

12


Table of Contents

NOTE 8—COMMITMENTS AND CONTINGENCIES

Litigation

Napster and Napster, LLC’s 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. 04-1549, 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 has answered the complaint and filed an application with the United States Patent and Trademark Office for reexamination of the patents. In January 2005, Napster moved for a stay of the proceedings pending the outcome of Napster’s reexamination application. On February 28, 2005, the court granted Napster’s motion to stay. The patents are currently being reexamined by the Patent Office. In or around November 2005, SightSound sold the patents in question to a subsidiary of General Electric for an undisclosed amount. Management believes that it is not currently possible to estimate the impact, if any, that the ultimate resolution of these matters will have on Napster’s business, results of operations, financial position or cash flows.

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 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, have moved for change of venue, and intend to defend themselves vigorously. Management believes that it is not currently possible to estimate the impact, if any, that the ultimate resolution of these matters will have on Napster’s 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.

Indemnification

In December 2004, Napster completed the sale of substantially all of the assets and liabilities of its consumer software division to Sonic Solutions, a California corporation (“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 Sonic’s 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.

 

13


Table of Contents

Obligations to content and distribution providers

Napster has certain royalty commitments associated with the licensing of the music content. Future payments under these content agreements are due to partners based upon net revenues and online music distribution volumes.

NOTE 9—RECENT ACCOUNTING PRONOUNCEMENTS

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation 48, “Accounting for Uncertainty in Income Taxes—an 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 accounting provisions of FIN 48 will be effective for the Company beginning April 1, 2007. The Company is in the process of determining the effect, if any, the adoption of FIN 48 will have on its financial statements.

 

14


Table of Contents

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION 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 below, in “Risk Factors” and elsewhere in this quarterly report.

Management’s Discussion and Analysis of Financial Condition and Results of Operations is organized as follows:

 

    Executive Summary—a high level discussion of the business including a discussion of our strategy, opportunities, challenges and risks.

 

    Critical Accounting Policies and Estimates—a discussion of accounting policies that require critical judgments and estimates.

 

    Results of Operations—an analysis of our consolidated results of operations for the periods presented in our financial statements.

 

    Liquidity and Capital Resources—an analysis of cash flows, sources and uses of cash, and contractual obligations.

 

    Recent Accounting Pronouncements—information on recent accounting pronouncements.

Executive Summary

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 and purchase from one of the world’s largest and most diverse online music catalogues utilizing a secure and legal platform. Napster users have access to songs from all major labels and hundreds of independent labels, and have many ways to discover, share and acquire new music and old favorites.

On May 1, 2006 we launched the new Napster.com, the only legal, advertising-supported service that offers free, on-demand listening without monthly restrictions. This free music site allows members in the United States to listen to nearly every song in Napster’s more than 2 million song subscription catalog three times each for free anywhere on the web without downloading any software. Napster.com members outside the United States enjoy free access to 30 second clips of these tracks.

For those consumers who want access to unlimited music, including the ability to download music with high quality sound, to enjoy their music in an advertising-free environment and to access many features including radio, Billboard charts and many community features, we offer Napster and Napster To Go subscriptions for use on the PC and/or portable devices. The paid Napster service is currently available in the United States, Canada, the United Kingdom and Germany. We expect to launch our paid service in Japan through a joint venture with Tower Records late in calendar 2006.

 

15


Table of Contents

We have historically derived our primary revenues from online subscriptions and permanent music downloads. Beginning in the first quarter of fiscal 2007, we began deriving revenue from advertising. 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 generally paid by end user customers in advance either via credit card, online payment systems or redemption of pre-paid cards, gift certificates or promotional codes. Napster also periodically licenses merchandising rights, resells hardware that our end users may utilize to store and replay their digital music content, and sells advertising in the free music service website.

Since the acquisition of Pressplay on May 19, 2003, our digital music distribution business has operated at a loss and negative cash flow. We expect to continue to operate at a loss and negative cash flow due to our significant investments to enhance service capabilities, market our products and grow worldwide.

Our paid music subscription services, Napster and Napster To Go, provide consumers in the United States with unlimited, high fidelity, access to over 2 million tracks for monthly fees of $9.95 and $14.95, respectively. Napster subscribers enjoy unlimited access to CD-quality music on up to three computers and have access to over 65 interactive radio stations, extensive community features, message boards, current and historical Billboard chart information and enhanced programming. Napster To Go subscribers can transfer an unlimited amount of music from Napster to their choice of over 60 compatible MP3 players for the entire term of their subscription without having to purchase individual tracks and albums. In addition, all Napster subscribers enjoy community features, such as the ability to send song links to friends, and our subscribers can browse other subscribers’ published collections. We also offer Napster and Napster To Go in Canada, Germany and the United Kingdom at fees that are based on the local currency. The feature sets and track availability in these countries vary slightly from the United States.

In addition to our Napster and Napster To Go offerings, we provide a separate download music store, called Napster Light, where customers who are not subscribers (including users of Napster.com) can purchase individual tracks for $0.99 each or albums starting at $6.95. These tracks can be “burned” to a CD or transferred to an MP3 player. Napster’s United States catalogue of available music exceeds two million tracks, and all content is licensed from major music companies, including EMI Recorded Music, Sony BMG, Universal Music Group and Warner Music Group, as well as numerous independent labels, on a non-exclusive basis.

The market for digital music is rapidly growing and we expect our digital music distribution business to continue to grow as the industry expands. This market is highly competitive and we expect competition to continue to increase in the future as the market expands. We believe that our brand, unique technology and feature set positions us ahead of many of our competitors. Our overall strategy is to drive consumers to Napster.com as a means to generate ad revenue and reduce our subscriber customer acquisition cost, continue to innovate by investing in new services and technologies, and continue to pursue and execute strategic partnerships. For example, Napster and Ericsson have signed an agreement with Suncom to deploy Napster Mobile in the South Eastern United States in the second quarter of fiscal 2007. Napster and Ericsson are also in discussions with several other wireless carriers worldwide.

 

16


Table of Contents

Critical Accounting Policies and Estimates

Management’s 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 three months ended June 30, 2006 to the items that we disclosed as our critical accounting policies and estimates in Management’s 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, 2006.

Revenue Recognition

We recognize revenues in accordance with Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements”, Emerging Issues Task Force (“EITF”) 00-21, “Revenue Arrangements with Multiple Deliverables” and EITF 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent”. In general, we recognize revenue, net of sales related taxes, when there is persuasive evidence of an arrangement, the fee is fixed or determinable, the product or services have been delivered and collectibility of the resulting receivable is reasonably assured.

Revenues from pre-paid cards and promotions are deferred and then recognized as (i) tracks are downloaded by the end users, (ii) if redeemed for a subscription, over the subscription period or (iii) when Napster has no further obligation to provide services or refund the associated prepayments (“prepaid card breakage”). As of June 30, 2006, we have not had sufficient historical experience to estimate breakage rates, so we recognize prepaid card breakage when our obligation to honor the redemption of prepaid cards or promotions has legally expired. In future periods management will continue to evaluate our actual breakage experience and determine when we have sufficient history to commence revenue recognition using breakage estimates.

Management exercises significant judgment in determining the fair value of multiple elements within revenue arrangements or separately identified goods or services, and in assessing when prepaid cards or prepaid royalties no longer involve a future obligation to provide services or refund the associated prepayments. These estimates represent our best estimates, but changes in circumstances relating to the products and services sold in these arrangements may result in one-time expense or revenue charges.

 

17


Table of Contents

Stock-based compensation

Effective April 1, 2006, Napster adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123(revised 2004) “Share-Based Payment” (“SFAS No. 123(R)”). SFAS No. 123(R) using the modified-prospective transition method. SFAS No. 123(R) requires that the fair value of all share-based payment awards made to employees and directors for services must be expensed over the period in which the services are provided.

Under SFAS No. 123(R), compensation expense for all share-based compensation awards is recognized on a straight-line basis over the period the employee performs the related services, generally the vesting period of four years, net of estimated forfeitures. Napster has estimated forfeitures based on historical experience and will revise the rates, if necessary, in subsequent periods if actual forfeitures differ from initial estimates.

Management uses historical data to estimate forfeiture rates on stock-based awards in recording stock-based compensation expense. To the extent actual results or updated estimates differ from our prior estimates, such amounts, if significant, will be recorded as a cumulative adjustment in the period that any such estimates are revised. If actual results differ significantly from what we previously estimated, our stock-based compensation expense and our results of operations could be materially impacted.

 

18


Table of Contents

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.

Net Revenues

The following table sets forth, for the periods indicated, the summary of our revenues (in thousands, except percentages):

 

    

Three Months Ended

June 30,

  

As a Percentage of
Net Revenues
Three Months Ended

June 30,

 
     2006    2005    2006     2005  
                   

Online music revenues:

          

Service

   $ 28,047    $ 20,751    100 %   99 %

Product and license

     69      250    %   1 %
                          

Total online music revenues

   $ 28,116    $ 21,001    100 %   100 %
                          

Service Revenues

Service revenues increased in the first quarter of fiscal 2007 as compared to the corresponding quarter of fiscal 2006 due primarily to growth in the online music market, consumer adoption of our products and international expansion. The Napster paid service was launched in the United States during October 2003, in the United Kingdom and Canada during May 2004 and in Germany during December 2005. Since the launch of the Napster paid music service in October 2003, our subscriber base has generally increased each quarter, excluding the cyclical impact of university subscribers. During the first quarter of fiscal 2007, excluding university subscribers, we saw our first quarter over quarter decrease in subscribers. This decrease is primarily attributable to a reduction in new customer acquisitions following the launch of our free advertising supported website, because prospective new customers are trying the free music service before subscribing to our premium music services. During the first quarter of fiscal 2007, customer churn excluding university subscribers remained at an historically low level. Total paid subscribers, excluding university subscribers, were 508,000 as of June 30, 2006, 547,000 as of March 31, 2006 and 402,000 as of June 30, 2005.

Typically we report subscribers as of the end of each quarter including both full paying subscribers and university subscribers. Given that the first quarter ends when most students are on summer break, we provide subscriber counts this quarter excluding the 4,000 university subscribers at June 30, 2006.

Service revenues in the first quarter of fiscal 2007 also included a one-time benefit of $1.9 million in prepaid card breakage related to the resolution of certain legal restrictions associated with previously sold prepaid cards.

 

19


Table of Contents

In the long term, we anticipate that service revenues will continue to increase as a result of marketing activities and initiatives designed to continue subscriber growth, expand internationally and decrease customer churn. Additionally, we expect to record a one-time benefit from prepaid card breakage later in fiscal 2007 after we have sufficient history to estimate breakage rates and begin recognizing prepaid card revenue net of estimated breakage. In the near term, we expect service revenues to decrease as prospective customers continue to delay subscribing to our premium music services while trying the free music services, which we experienced in the first quarter of this year. Our agreement with Best Buy expired on June 30, 2006. This partnership contributed only $100,000 of new gross paid subscriber revenue and $600,000 of prepaid card sales during the first quarter of fiscal 2007.

Product and License Revenues

Product and license revenues decreased in the first quarter of fiscal 2007 as compared to the corresponding quarter of fiscal 2006 primarily due to the timing of product and promotional programs. We expect that product and license revenues will fluctuate depending on the product promotions and licenses that we enter into each quarter.

Geographic Revenues

The following table sets forth, for the periods indicated, the summary of our revenues per geographic region (in thousands, except percentages):

 

     Three Months Ended
June 30,
  

As a Percentage of
Net Revenues
Three Months Ended

June 30,

 
     2006    2005    2006     2005  

Online music revenues:

          

North America

   $ 24,240    $ 18,475    86 %   88 %

Europe

     3,876      2,526    14 %   12 %
                          

Total online music revenues

   $ 28,116    $ 21,001    100 %   100 %
                          

The increase in revenues in both geographies is generally related to the steady growth of the online music service worldwide and the launch of the service in Germany in December 2005. Revenue in North America includes the one-time benefit of $1.9 million in prepaid card breakage. 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.

 

20


Table of Contents

Gross Margin

The following table sets forth, for the periods indicated, our gross margins (in thousands, except percentages):

 

     Three Months Ended
June 30, 2006
  

As a Percentage of
Related Revenues
Three Months Ended

June 30, 2006

 
     2006     2005    2006     2005  

Online music gross margin:

         

Service

   $ 9,040     $ 6,464    32 %   31 %

Product and license

     (46 )     132    (67 )%   53 %
                   

Total online music gross margin

   $ 8,994     $ 6,596    32 %   31 %
                   

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 and certain identifiable intangible assets related to the delivery of the services, and any other direct costs of providing the services. Product and license gross margin is the profit from revenues after deducting the cost of product sold, order fulfillment services, product shipping costs and any other direct expenses related to product and license sales.

Service gross margin increased one percentage point in the first quarter of fiscal 2007 as compared to the corresponding quarter of fiscal 2006 primarily due to $2.2 million of prepaid card breakage revenue recognized in the first quarter of fiscal 2007, which has no cost of revenues, offset by $646,000 promotional breakage in the first quarter of fiscal 2006, which has no cost of revenues. Excluding the prepaid card and promotional breakage revenues, service gross margin in the first quarter of fiscal 2007 decreased three percentage points from the first quarter of fiscal 2006. This change is primarily due to increased label royalty rates and additional ongoing expenditures for service infrastructure, offset in part by a change in revenue mix from download revenues to subscription revenues, which have a higher gross margin.

Product and license gross margin decreased in the first quarter of fiscal 2007 as compared to the corresponding quarter of fiscal 2006 due primarily to a negative margin hardware promotion in fiscal 2006.

Service headcount dedicated to maintaining content and providing customer care was 12 and 11 at June 30, 2006 and 2005, respectively.

We expect gross margins as a percentage of revenue to be adversely impacted to the extent that we continue to fund low margin promotions or spend to improve our service infrastructure. Excluding one-time items and low margin hardware promotions, we expect margins to continue to improve slightly as we return to revenue growth in the second half of fiscal 2007. We expect advertising revenues from the Napster.com free music service to positively impact gross margin in the future.

 

21


Table of Contents

Operating Expenses

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, rent and allocated facilities 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):

 

     Three Months Ended
June 30,
  

As a Percentage of
Net Revenues
Three Months Ended

June 30,

 
     2006    2005    2006     2005  

Research and development

   $ 2,937    $ 3,195    11 %   15 %

Sales and marketing

     10,471      16,272    37 %   77 %

General and administrative

     5,988      6,196    21 %   30 %

Amortization of intangible assets

          474    %   2 %
                          
   $ 19,396    $ 26,137    69 %   124 %
                          

Research and Development

Research and development 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.

Research and development expenses decreased in the first quarter of fiscal 2007 as compared to the corresponding quarter of fiscal 2007 due primarily to lower headcount. Such decrease was partially offset by an increase of $164,000 for stock-based compensation following the adoption of SFAS No. 123(R) on April 1, 2006.

Research and development headcount was 62 and 65 as of June 30, 2006 and 2005, respectively.

We anticipate that research and development expenses will increase near term as we focus on the continued investment in new products and functionality.

 

22


Table of Contents

Sales and Marketing

Sales and marketing expenses consist primarily of salary and benefits 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 in the first quarter of fiscal 2007 as compared to the corresponding quarter of fiscal 2006 due to the reduction in U.S. marketing programs. Such decrease was partially offset by an increase of $134,000 for stock-based compensation following the adoption of SFAS No. 123(R) on April 1, 2006.

Sales and marketing headcount increased to 31 at June 30, 2006 from 29 at June 30, 2005.

We expect sales and marketing expenses for the remainder of fiscal 2007 will remain constant as we continue to control spending and focus on lowering customer acquisition costs. In the long-term, sales and marketing expenses may increase due to advertising sales commissions.

General and Administrative

General and administrative expenses consist primarily of salary and benefit costs (including stock-based compensation) for executive and administrative personnel, professional services, administrative outsources and other general corporate activities.

General and administrative expenses decreased in the first quarter of fiscal 2007 as compared to the corresponding quarter of fiscal 2006 due primarily to reduced headcount, bonus costs and legal fees during the first quarter of fiscal 2007. Such decrease was partially offset by an increase of $538,000 for stock-based compensation following the adoption of SFAS No. 123(R) on April 1, 2006.

General and administrative headcount, including all corporate general and administrative employees, was 41 at June 30, 2006 compared to 42 at June 30, 2005.

We expect general and administrative expenses to remain constant in the near term as we focus on controlling operating expenses.

Amortization of Intangible Assets

Amortization of intangible assets consists of amortization expense related to the intangible assets recorded in connection with our acquisition of Napster’s name in December 2002 and Napster, LLC, formerly known as Pressplay, in May 2003. Amortization of intangible assets was $474,000 in the first quarter of fiscal 2006. There was no amortization of intangible assets in the first quarter of fiscal 2007 because identifiable intangible assets were fully amortized as of March 31, 2006. Unless we acquire new intangible assets, we do not expect future amortization expense.

Loss from Unconsolidated Entity

The loss from unconsolidated entity represents our 31.5% portion of the loss incurred by Napster Japan during the periods presented. Napster Japan was formed during October 2005, and this loss represents our share of the company’s start-up expenses. We expect losses from Napster Japan to increase as it prepares for the launch of the Napster service in Japan late in calendar 2006.

 

23


Table of Contents

Other Income (Expense), Net

Other income (expense), net, consists primarily of interest income on our cash equivalents and short-term investments, realized gains (losses) on short-term investments, interest expense, change in the fair value of the hedge and other miscellaneous income.

Other income (expense), net increased $1.3 million to $1.2 million in the first quarter of fiscal 2007 as compared to ($120,000) in the corresponding quarter of fiscal 2006 primarily due to a $571,000 reduction in foreign currency losses and the elimination of the hedge on our shares of Sonic Solutions, which carried a $313,000 discount during the first quarter of fiscal 2006. These decreases were partially offset by a $307,000 increase in investment income.

We expect other income, net to decrease in the future as investments are used to fund operations. Other income, net will also fluctuate due to foreign currency fluctuations.

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 Consumer Software Division (“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 provision was $267,000 for the first quarter of fiscal 2007 as compared to $265,000 in the corresponding quarter of fiscal 2006. Such provisions represent primarily foreign taxes and the timing difference related to the Pressplay goodwill. In the near term, we expect to continue to incur operating losses from operations.

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.

Liquidity and Capital Resources

At June 30, 2006, Napster had $97.8 million in cash, cash equivalents and short-term investments. These amounts consist principally of commercial paper, corporate securities, U.S. government securities, municipal securities, certificates of deposit and money market securities. This balance represents a $6.3 million decrease as compared to cash, cash equivalents, short-term investments and foreign currency in-transit at March 31, 2006. 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. Our working capital was $66.6 million at June 30, 2006 compared to $74.4 million at March 31, 2006.

 

24


Table of Contents

Line of Credit

As of June 30, 2006, we have $17.0 million available for borrowing under our line of credit. The line of credit bears interest at a variable rate of prime plus 0.5% per annum. The line of credit contains a material adverse conditions clause and covenants that require us to maintain certain financial ratios. The covenants require at the end of each month and throughout the term of the agreement (i) a minimum tangible net worth of $45.0 million, (ii) a ratio of unrestricted cash, cash equivalents and short-term investments, plus 10% of net accounts receivable, to total borrowings under the line of credit of not less than 2.00 to 1.00. At June 30, 2006, we were in compliance with all covenants under the line of credit and had no outstanding borrowings under this line.

Financial Position

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 and net negative cash flow due to significant investments required to expand its service capabilities and to expand internationally.

We do not currently hold any variable interest rate debt, and we have no outstanding borrowings under our revolving line of credit. 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.

Cash Flows

Operating Activities

Net cash used in operating activities was $8.1 million in the first three months of fiscal 2007 as compared to $15.4 million in the corresponding period of fiscal 2006, due primarily to a $10.1 million decrease in our operating loss in the first quarter of fiscal 2007. Additionally, Napster had approximately $1.1 million fewer non-cash expenses in the first quarter of fiscal 2007 and an additional $2.2 million in non-cash revenue from prepaid card breakage.

Investing Activities

Net cash provided by investing activities increased to $4.0 million in the first three months of fiscal 2007 as compared to $15.7 million used in investing activities in the corresponding period of fiscal 2006. The significant increase in cash provided by investing activities was primarily due to the investment of remaining cash proceeds from the sale of CSD to Sonic during the first quarter of fiscal 2006, and the utilization of investments for operating cash during the first quarter of fiscal 2007. We also received a $2.2 million payment related to the CSD divestiture and completed the conversion of $7.5 million of foreign currency to US Dollars during April 2006.

We expect to use investments in the future as we use short-term investments to fund operating cash flows.

Financing Activities

Net cash used in financing activities decreased to $135,000 in the first three months of fiscal 2007 as compared to $15.0 million in the corresponding period of fiscal 2006, primarily due to the repayment of our $15.0 million line of credit in May 2005.

 

25


Table of Contents

Off-Balance Sheet Arrangements

As of June 30, 2006, 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 9 – 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.

 

26


Table of Contents

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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 two years.

The following table presents the amounts of our short-term investments that are subject to market risk by range of remaining expected maturity and weighted-average interest rates as of June 30, 2006. Our cash equivalents are invested in commercial paper, money market funds and certificates of deposit, which are not included in the table because those funds are not subject to interest rate risk due to their short maturities (in thousands, except interest rates).

 

     Less than
One Year
    More than
One Year
    Total    Estimated
Fair Value

Short-term investments

   $ 47,942     $ 7,227     $ 55,169    $ 55,169

Weighted-average interest rate

     4.48 %     5.27 %     

We have available to us a $17 million revolving line of credit. At June 30, 2006, there was no balance outstanding on the revolving line of credit. We do not have any outstanding variable interest rate debt as of June 30, 2006.

Financial instruments that potentially subject us to significant concentrations of credit risk consist principally of trade accounts receivable and accounts payable.

 

27


Table of Contents

Exchange Rate Risk

We market our Napster service in the United States, Canada, the United Kingdom and Germany, resulting in sales denominated in U.S. dollars, Canadian dollars, United Kingdom pounds and Euro. Additionally we have agreements with our Japanese Joint Venture that are denominated in 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 June 30, 2006, we held $3.9 million of cash and cash equivalents in United Kingdom pounds, $1.2 million in Euro and $609,000 in other foreign currencies.

ITEM 4. CONTROLS AND PROCEDURES

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 ensure that information we are required to disclose in reports that we file or submit under the Exchange Act (i) is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (ii) 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. Our disclosure controls and procedures are designed to provide reasonable assurance that such information is accumulated and communicated to our management. Our disclosure controls and procedures include components of our internal control over financial reporting.

Changes in Internal Control Over Financial Reporting

During the quarter ended June 30, 2006, 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.

 

28


Table of Contents

PART II—OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

For legal proceedings, see Note 8 – Commitments And Contingencies to the condensed consolidated financial statements appearing in Item 1, Part I to this quarterly report, which are incorporated by reference into this Item 1, Part II.

ITEM 1A. RISK FACTORS

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 annual 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 new and unproven. Prior to our acquisition of Napster, LLC, consumer adoption and usage of the Pressplay-branded service had not been significant. On December 17, 2004, we completed the sale of our consumer software division to Sonic Solutions and have subsequently focused our business exclusively on paid digital music distribution and our recently launched advertising-supported music website, under the Napster brand. 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 and capital 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 June 30, 2006, we incurred approximately $165.5 million of after tax losses from continuing operations.

 

29


Table of Contents

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 to the paid Napster service or that existing subscribers will continue to subscribe. Existing subscribers may cancel their subscriptions to the paid Napster service 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. The early stages of subscription services such as ours are characterized by higher than normal churn rates and customer acquisition cost. If we are unable to reduce these two factors we may be unable to achieve a profitable business model. In addition, there is significant seasonality in our subscriber numbers due to our university program and softness in customer acquisition during the summer months when consumers spend less time online. Students who subscribe to the paid Napster service generally only do so during the school year when the school is paying for their subscriptions and most of the students do not maintain such subscriptions during the summer in between school terms. If we do not continue to increase the total number of subscribers each quarter, our operating results will be adversely impacted.

If advertising revenues were to fail to grow as expected, our results of operations and business would be harmed.

Revenues from advertising are important to the future success of our business. Advertising revenues are based on the number of page views by visitors to the Napster.com Web site. If our free music service fails to attract and retain visitors, our revenues will not grow as expected. Most advertisers currently spend only a small portion of their advertising budgets on Internet advertising. There are also significant lead times associated with securing these advertising dollars. Furthermore, expenditures by advertisers tend to be cyclical, reflecting overall economic conditions and budgeting and buying patterns. If we fail to persuade potential advertisers to spend a portion of their budget on advertising with us, or if advertising spending declines due to general economic conditions or the failure of the Internet to be an effective advertising medium, our business and revenues could be adversely affected. In addition, sales of advertisements occur under short-term contracts, which are difficult to forecast accurately. Advertisers generally have the right to cancel an advertising campaign on short notice without penalty. Accordingly, the cancellation or deferral of advertising agreements could have a material adverse effect on our financial results.

 

30


Table of Contents

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:

 

    timing of service introductions;

 

    seasonal fluctuations in sales of our prepaid cards, university subscriptions, and bundled hardware promotions, as well as other products and services;

 

    potential declines in selling prices of music as a result of competitive pressures;

 

    changes in the mix of our revenues represented by our various services;

 

    fluctuations in traffic levels on our Web sites, which can be significant as a result of business, financial and other news events;

 

    fluctuating and unpredictable demand for advertising on our Web sites as well as on the Web in general;

 

    reductions in rates paid for Web advertising resulting from softening demand, competition, or other factors;

 

    adverse changes in the level of economic activity in the United States or other major economies in which we do business, or in industries, such as the music industry, on which we are particularly dependent;

 

    foreign currency exchange rate fluctuations;

 

    expenses related to, and the financial impact of, possible acquisitions of other businesses; and

 

    expenses incurred in connection with the development of our digital music distribution services.

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 have embarked on 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.

 

31


Table of Contents

We face significant competition from traditional retail music distributors, from emerging paid online music services delivered electronically such as ours, and from “free” peer-to-peer services.

Our paid Napster service faces 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 Computer’s iTunes Music Store, AOL Music Now, RealNetworks, Inc., the provider of the Rhapsody service, MTV’s Urge, Sony Connect, Walmart.com, FYE, Microsoft’s MSN Music service and online music services powered by MusicNet such as Yahoo! Music Unlimited, MTV’s Urge, Virgin, V-cast and Sprint. Other potential competitors such as Amazon.com have announced their intention to provide competing music distribution services. Internationally we currently compete with OD2, Puretracks, 3 Music Store and Vodafone’s music offerings, 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 KaZaA, Morpheus, Grokster 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 another’s hard drives, all without securing licenses from content providers. While the U.S. Supreme Court has recently 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. The ongoing presence of these “free” services substantially impairs the marketability of legitimate services, regardless of the ultimate resolution of their legal status.

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 also face intense competition from general purpose consumer online services such as Yahoo, MSN and Google, each of which provides access to music-related content and services and from websites targeted to music related content, such as Yahoo and myspace.com. Finally, we compete directly for content and for users of our advertising-supported website from community-generated information websites that include music-related content, such as Wikipedia.

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.

 

32


Table of Contents

In particular, some of these 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 will 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.

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.

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 be able to continue 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 rights 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. 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 proposed rates for statutory webcasting that were significantly in excess of rates requested by webcasters. 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. Such licenses may only apply to music performed in the United States. The availability of licenses for compositions used in certain international versions of the services is unclear. Therefore, our ability to negotiate appropriate licenses is uncertain.

 

33


Table of Contents

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. No final agreement has been reached with performing rights societies such as ASCAP or BMI regarding whether digital downloads constitute public performances of copyrighted works that would trigger payment of public performance royalties. In addition to certain other negotiations, European Union and Canadian tribunals are 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 management’s 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 management’s estimate, the actual amount paid and expensed could differ materially from the recorded amounts.

Our success depends on our digital music distribution service’s interoperability with our customer’s 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 home stereos, car stereos, portable MP3 players, cell phones, PCs and other mobile devices. 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 service and certain current manufacturers may not be able to profitably continue to offer existing devices. Our software is not compatible with the iPod music player, the current equipment market leader. If we cannot successfully design our service to interoperate with the music playback devices that our customers own, 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.

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.

 

34


Table of Contents

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, retailers 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. For example, our agreement with Best Buy recently terminated. 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 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:

 

    our own or licensed encryption and authentication technology, and access and security procedures, may be compromised, breached or otherwise be insufficient to ensure the security of customer information or our music content;

 

    we could experience unauthorized access, computer viruses, system interference or destruction, “denial of service” attacks and other disruptive problems, whether intentional or accidental, that may inhibit or prevent access to our web sites or use of our products and services;

 

    someone could circumvent our security measures and misappropriate our, our partners’ or our customers’ intellectual property or interrupt operations, or jeopardize our licensing arrangements, which are contingent on our sustaining appropriate security protections;

 

    our computer systems could fail and lead to service interruptions;

 

    we may be unable to scale our infrastructure with increases in customer demand; or

 

    our network of facilities may be affected by a natural disaster, terrorist attack or other catastrophic events.

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.

 

35


Table of Contents

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 the services of these key officers and employees could harm our business. If any of these individuals were to leave our company, we could face substantial difficulty in hiring qualified successors 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. In addition, we plan to continue to hire a significant number of employees in the next twelve months for the development of new products and services. This anticipated growth in future operations will place a significant strain on our management resources.

In the future, we plan to continue to develop and improve our financial and managerial controls, reporting systems and procedures. In addition, we plan to continue to expand, train and manage our work force worldwide.

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.

 

36


Table of Contents

A significant portion of the revenues from our paid Napster service 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 worldwide, our business is subject to risks associated with doing business internationally. International net revenues did not account for a significant percentage of our net revenues prior to the sale of our consumer software division; however, 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 service abroad and enter into joint venture arrangements with international partners such as Tower Records Japan, Inc. Accordingly, our future revenues could decrease based on a variety of factors, including:

 

    disputes with joint venture partners;

 

    mismanagement or fraud by joint venture partners;

 

    changes in foreign currency exchange rates;

 

    seasonal fluctuations in sales of our prepaid cards as well as other products and services;

 

    changes in a specific country’s or region’s political or economic condition, particularly in emerging markets;

 

    unexpected changes in foreign laws and regulatory requirements;

 

    difficulty of effective enforcement of contractual provisions in local jurisdictions;

 

    trade protection measures and import or export licensing requirements;

 

    potentially adverse tax consequences including changes to the VAT collection scheme;

 

    difficulty in managing widespread sales operations; and

 

    less effective protection of intellectual property.

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.

 

37


Table of Contents

We may be subject to intellectual property infringement claims, such as those claimed by SightSound Technologies, 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 resorted to litigation regarding intellectual property rights. We may be forced to litigate to determine the validity and scope of other parties’ proprietary rights. Any such litigation could be very costly and could distract our management from focusing on operating our business. 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. As we develop products and services that provide or enable the provision of content, in such ways, our litigation risk may increase. The existence and/or outcome of such litigation could harm our business.

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 the other third parties’ 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. 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.

 

38


Table of Contents

We may be subject to legal liability for online services.

Our free music service allows individuals and businesses to post content, advertise products and services, conduct business and engage in various online activities on an international basis. The law relating to the liability of providers of these online services for activities of their users is currently unsettled both within the United States and internationally. Claims have been threatened and have been brought against similar website owners for defamation, negligence, copyright or trademark infringement, unlawful activity, tort, including personal injury, fraud, or other theories based on the nature and content of information that such websites provide links to or that may be posted online or generated by users. We may be subject to similar actions in domestic or other international jurisdictions in the future. Although we generally will obtain representations as to the origin and ownership of content licensed from third parties and generally will obtain indemnification from these third parties to cover a breach of any such representation, we may not receive representations or indemnification that are sufficient to cover all liability relating to the third-party content. Our defense of any such actions could be costly and involve significant time and attention of our management and other resources.

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 affect 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 depend on software from third parties to deliver and to track and measure the delivery of advertisements and it could be difficult to replace these services.

It is important to our future success that we are able to effectively deliver our advertisers’ advertisements and it is important to our advertisers that we accurately measure the delivery of such advertisements on our websites. We depend on third-party software to provide these measurement and delivery services. If these third parties are unable to provide these services in the future, we would be required to perform them ourselves or obtain them from other providers. This could cause us to incur additional costs or cause interruptions in our business during the time we are replacing these services. Companies may not advertise on our websites or may pay less for advertising if they do not perceive our measurements or measurements made by third parties to be reliable.

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.

 

39


Table of Contents

Changes in stock option accounting rules may adversely impact our reported operating results prepared in accordance with generally accepted accounting principles, our stock price and our competitiveness in the employee marketplace.

Technology companies like ours have a history of using broad-based employee stock option programs to hire, provide incentives to and retain our workforce in a competitive marketplace. Prior to April 1, 2006, we had elected to apply Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), to account for stock options. Accordingly we generally had not recognized any expense with respect to employee stock options as long as such options are granted at exercise prices equal to the fair value of our common stock on the date of grant.

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”), which revised the previously effective SFAS No. 123, “Accounting for Stock-Based Compensation”, and superseded APB No. 25. This statement addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for either equity instruments of the enterprise or liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The statement eliminates the ability to account for share-based compensation transactions using APB No. 25 and generally requires that such transactions be accounted for using a fair-value-based method and recognized as expenses in our consolidated statements of operations. The effective date of the standard for public companies is for the first annual reporting periods beginning after June 15, 2005. We have adopted SFAS No. 123(R) effective April 1, 2006.

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. 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.

 

40


Table of Contents

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, gambling, 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 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:

 

    limit the growth of the Internet;

 

    create uncertainty in the marketplace that could reduce demand for our products and services;

 

    increase our cost of doing business;

 

    expose us to increased litigation risk, substantial defense costs and significant liabilities associated with content available on our web sites or distributed or accessed through our products or services, with our provision of products and services and with the features or performance of our products and web sites;

 

    lead to increased product development costs or otherwise harm our business; or

 

    decrease the rate of growth of our user base and limit our ability to effectively communicate with and market to our user base.

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 escheat, 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.

 

41


Table of Contents

We may need to make additional future acquisitions to remain competitive. The process of identifying, acquiring and integrating future acquisitions may constrain valuable management resources, and our failure to effectively integrate future acquisitions may result in the loss of key employees and the dilution of stockholder value and have an adverse effect on our operating results.

We have completed several acquisitions and may continue to pursue strategic acquisitions in the future. Completing any potential future acquisitions could cause significant diversions of management time and resources. Financing for future acquisitions may not be available on favorable terms, or at all. If we identify an appropriate acquisition candidate, we may not be able to negotiate the terms of the acquisition successfully, finance the acquisition or integrate the acquired business, products, technologies or employees into our existing business and operations. Future acquisitions may not be well-received by the investment community, which may cause our stock price to fall. We have not entered into any agreements or understandings regarding any future acquisitions and cannot ensure that we will be able to identify or complete any acquisition in the future.

If we acquire businesses, new products or technologies in the future, we may be required to amortize significant amounts of identifiable intangible assets, and we may record significant amounts of goodwill that will be subject to annual testing for impairment. If we consummate one or more significant future acquisitions in which the consideration consists of stock or other securities, our existing stockholders’ ownership could be significantly diluted. If we were to proceed with one or more significant future acquisitions in which the consideration included cash, we could be required to use a substantial portion of our available cash.

We may be subject to market risk and legal liability in connection with the data collection capabilities of our products and services.

Many of our products are interactive Internet applications which by their very nature require communication between a client and server to operate. To provide better consumer experiences and to operate effectively, our products send information to servers. Many of the services we provide also require that a user provide certain information to us. We post an extensive privacy policy concerning the collection, use and disclosure of user data involved in interactions between our client and server products. Any failure by us to comply with our posted privacy policy and existing or new legislation regarding privacy issues could impact the market for our products and services, subject us to litigation and harm our business.

If, in the future, we conclude that our internal control over financial reporting is not adequate, or if our auditors conclude that our evaluation of internal controls over financial reporting is not adequate, 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 company’s 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 company’s internal control over financial reporting. In addition, the independent registered public accounting firm auditing a public company’s financial statements must attest to and report on management’s assessment of the effectiveness of the company’s 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 its operations.

 

42


Table of Contents

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 operation 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.

We hold cash in foreign subsidiaries, which we may repatriate to the United States, and which may result in income taxes that could negatively impact our results of operations and financial position.

We are in the process of completing a corporate restructuring to close the overseas operations of certain dormant subsidiaries of our former consumer software division. We may repatriate our cash from these foreign subsidiaries to the United States. We may incur additional income taxes from the repatriation, which could negatively affect our results of operations and financial position.

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.

 

43


Table of Contents

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

Exhibits

The exhibits listed on the Exhibit Index (following the Signatures section of this report) are included, or incorporated by reference, in this quarterly report.

 

44


Table of Contents

SIGNATURES

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.

 

   

NAPSTER, INC.

 

(Registrant)

Date: August 2, 2006   By:  

/s/ WM. CHRISTOPHER GOROG

   

Wm. Christopher Gorog

Chief Executive Officer

(Principal Executive Officer)

  By:  

/s/ NAND GANGWANI

   

Nand Gangwani

Vice President and

Chief Financial Officer

(Principal Financial and Accounting Officer)

 

45


Table of Contents

INDEX TO EXHIBITS

 

Exhibit
Number
  

Description of Exhibit

2.1    Purchase Agreement among the Registrant, UMG Duet Holdings, Inc., a Delaware corporation, and SMEI Duet Holdings, Inc., a Delaware corporation, dated May 19, 2003 (1)
2.2    Amended and Restated Asset Purchase Agreement between the Company and Sonic Solutions, dated December 17, 2004 (2)
3.1    Amended and Restated Certificate of Incorporation of the Registrant (3)
3.2    Amended and Restated Bylaws of the Registrant (4)
3.3    Certificate of Designation of Rights, Preferences and Privileges of Series A Participating Preferred Stock of Roxio, Inc. (5)
4.1    Form of Common Stock certificate of the Registrant (2)
4.2    Preferred Stock Rights Agreement, dated as of May 18, 2001, between Registrant and Mellon Investor Services, LLC, including the Certificate of Designation, the form of Rights Certificate and the Summary of Rights attached thereto as Exhibits A, B, and C, respectively (5)
4.3    Form of Purchase Agreement dated as of June 18, 2003 by and between the Registrant and certain Purchasers set forth on the signature page thereto (6)
4.4    Amended and Restated LLC Operating Agreement of Napster, LLC dated May 19, 2003 by and between Registrant, UMG Duet Holdings, Inc. and SMEI Duet Holdings, Inc. (4)
4.5    Form of Purchase Agreement dated as of January 13, 2004 by and between Napster and certain Purchasers set forth on the signature page thereto (7)
4.6    Registration Rights Agreement dated June 17, 2004 between the Registrant and Best Buy Enterprise Services Inc. (8)
4.7    Common Stock Purchase Agreement between Registrant and Best Buy Enterprise Services Inc. dated June 17, 2004 (8)
4.8    Form of Purchase Agreement dated as of January 20, 2005 by and between Registrant and certain Investors (9)
31.1    Certification of Chief Executive Officer required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2    Certification of Chief Financial Officer required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1    Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1) Incorporated by reference to the Registrant’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on May 19, 2003.
(2) Incorporated by reference to the Registrant’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on December 23, 2004.
(3) Incorporated by reference to the Registrant’s Form 10 Registration Statement (No. 000-32373) as filed with the Securities and Exchange Commission on May 15, 2001.
(4) Incorporated by reference to the Registrant’s Annual Report on Form 10-K as filed with the Securities and Exchange Commission on June 30, 2003.
(5) Incorporated by reference to the Registrant’s Registration Statement on Form 8-A as filed with the Securities and Exchange Commission on June 5, 2001.
(6) Incorporated by reference to the Registrant’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on June 20, 2003.

 

46


Table of Contents
(7) Incorporated by reference to the Registrant’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on January 13, 2004.
(8) Incorporated by reference to the Registrant’s Registration Statement on Form S-3 (No. 333-117520) as filed with the Securities and Exchange Commission on July 20, 2004.
(9) Incorporated by reference to the Registrant’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on January 21, 2005.

 

47