RealNetworks: Time to Sell Rhapsody?

A shaky music-subscription business model and mounting competition suggest Real could do better to focus on wireless messaging and casual gaming

By Arik Hesseldahl

Shares of RealNetworks (RNWK) have been on a roller coaster lately. Consider the two-day period in early September, when the stock surged 7% on news that its music subscription services would be available on the iPhone—only to give up those gains the following day, after a bearish report from an analyst.

Six months earlier, on Mar. 9, the company had tumbled to an all-time low of 2, leaving its market value below its cash—a sign of a company that's either undervalued or headed for trouble. RealNetworks' stock has rebounded since then, closing at 3.80 on Sept. 28, but the company still faces a raft of challenges, many related to its subscription music business, Rhapsody. To keep the stock headed in the right direction, RealNetworks executives may want to consider exiting the consumer music business altogether.

Expenses at the music business are outpacing top-line growth just as an already crowded streaming music field may need to accommodate another player—the formidable Apple (AAPL). RealNetworks has other businesses to fall back on. Its largest, the products and services group, helps text and multimedia messages cross competing wireless phone networks and could be augmented through acquisitions. RealNetworks also has a casual gaming business.

One of the toughest obstacles for the Rhapsody music business is the pace of expense growth. In its most recent quarter, music sales rose 9% to $40.4 million, or 30% of the company's total revenues. Expenses rose more than twice as much, increasing 21% to $25 million, accounting for 62% of the total. As Rhapsody attracts more subscribers—the tally rose 150,000 from a year earlier—it has to pay more in royalties to record labels. "The ideal Rhapsody subscriber is one who doesn't use the service much because the more you use it, the more it costs RealNetworks in royalties," says Pacific Crest Securities analyst Andy Hargreaves. "I don't understand how the math changes for the better with more subscribers."

Pandora Is Free While Apple Lurks

Worse, subscriber revenue has recently shifted to lower-margin services, RealNetworks said in an Aug. 7 filing with the Securities & Exchange Commission. RealNetworks Chief Financial Officer Mike Eggers says that over time, subscriber increases do not result in "significant" increases in royalty fees and that eventually, the subscriber base will be large enough to reach breakeven. Currently Rhapsody has 750,000 subscribers who pay between $12.99 and $14.99 a month for on-demand music. The site also has dozens of free streaming music stations.

Expenses aside, it's getting harder to stand out in a business where online music streaming is becoming increasingly cheap and easy to find. Take Pandora, which lets users set up their own radio stations based on their musical tastes. It also offers music subscriptions, but most of Pandora's 30 million users listen to the ad-based service at no charge.

Rhapsody's plight would become infinitely more challenging in the event that Apple, as rumored, were to set up its own music subscription service. "Apple could turn that service on in a day," Hargreaves says. "The competitive environment would get difficult real quick." An Apple representative declined to comment.

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