RealNetworks: A Turnaround Situation

RealNetworks, Inc. (NASDAQ:RNWK) is a digital entertainment company that provides digital media services and software. It is known for Rhapsody, a subscription- and advertising-funded music service that offers downloads and on-demand streaming services; RadioPass, an Internet radio subscription service; and RealMusic. The company also has a gaming business that owns and operates subscription services for the PC and other platforms. We’re initiating coverage on this company based on my interest in turnaround situations and strategies–diamonds in the rough, so to speak.

RealNetworks is known for many firsts in the industry. RealPlayer is the first media player that allowed audio and video streaming and downloading on the Internet. RealDVD is the first ever product that allowed users to copy DVD data as backup onto their hard drives. They are the leader in digital entertainment services provided through wireless carriers and are the largest subscription-based music service in the United States.

The company’s focus areas are games and music. RealNetworks operates its games unit as a pure-play company and intends to spin off the unit as a separate entity in the future. However, due to the poor economy, the timeline for the separation has not been fixed. The company produces and distributes casual video games for the growing gaming market. To address the community gaming market, it integrated the new community games with the AIM client in addition to launching other community features.

Within music, RealNetworks has tied up with many partners to provide on-demand subscription-based music. Within the United States, they operate the third-largest online digital MP3 store and are projecting growth in the segment through advancement in technology and partnerships. They have launched solutions that integrate Rhapsody with TV set-top boxes, home entertainment systems, and mobile devices. In addition to a partnership with Viacom, they offer services through Verizon and are looking to transform to a Web services platform that will be integrated with other social networking sites such as Facebook and other music sites such as Yahoo! music.

A year ago, RealNetworks recorded 7% growth in revenues to $605 million with a net loss of $1.74 per share. Revenues grew 24% in the Games segment to $135 million and 8% in the Music segment to $161 million. Revenues of $207 million in the Technology Product and Solutions group and $103 million in the Media segment were flat.

The company’s most recent reported revenues of $135.7 million for Q2 fell 11% over the year compared with $152.6 million a year ago. Excluding the impact of foreign currency movements, revenue would have fallen 7% over the year. RealNetworks suffered a loss of $1.40 per share compared with a loss of a cent per share. The market was expecting revenues of $138.4 million and a loss of $0.06 per share.

By segment, Music revenues grew by 9% over the year to $40.5 million. However, Technology Products and Solutions revenue fell 10% to $46.2 million, Games revenues declined 15% to $29.8 million, and the Media Software and Services segment fell 34% over the year to $19.3 million.

Real’s Rhapsody, a leading provider of digital music, is a joint venture with Viacom. Rhapsody currently has nearly 750,000 subscribers who pay a monthly fee ranging from $12.99 to $14.99 for unlimited on-demand song streaming. However, the business is struggling because of the depressed economy and intense competition from players such as Pandora, which offers personalized radio stations with free music streaming. While revenues from the segment grew 9% over the year, expenses grew 21% in the quarter. To control expenses, RealNetworks looking at job cuts targeted to reduce headcount by 9%.

To address the iPhone segment, Rhapsody recently launched a subscription-based music service. This is the first time ever that Apple has allowed any on-demand music service on its phone in the United States. The service allows users to create playlists, stream to the device, and queue up to 8 million songs. The service is an extension of the already available Rhapsody To Go, which allows users to load songs onto their Windows Media Player-enabled phones and players when connected for later playback.

The company’s other media product, RealDVD, is also facing trouble. RealNetworks is in the middle of a legal dispute with Hollywood movie studios, which object to the company’s software that permits consumers to copy DVD movies to hard drives, thus violating the Digital Millennium Copyright Act. RealNetworks has already lost the first round of the case.

Real Networks is also facing legal trouble with VeriSign, which is seeking material damages. The company has already lost arbitration on a partnership from 2001 in which VeriSign alleges that Real Networks prevented the former from selling some of its business units.

Amid such legal battles and uncertain economic conditions, RealNetworks still expects revenues to increase sequentially in the current quarter. However, revenues will continue to decline over the year in all segments. Given that the global gaming industry is expected to grow at a compounded rate of 10.3% per year to $68.3 billion by 2012, RealNetworks has solid growth potential. The company needs a strategic overhaul and needs to resolve its legal troubles. But once those problems are taken care of, a turnaround could very well take place.

After having reached a five-year low of 2.02 in March of this year, the stock has recovered significantly and is trading at $4.08 with a market capitalization of nearly $500 million.