Description

Liquid Audio, Inc. (LQID) is a company that sells digital music over the Internet. The company, like many of its Internet related cousins, was given sizable amounts of cash from investors but has yet to live up to the high expectations it had set out to achieve. The company has never produced a profit.

While this sounds like an unattractive situation, certain events have transpired that will create value for LQID shareholders.

Financial Data (9/30/01):

Diluted Shares Outstanding: 23 million
Stock Price: $2.32
Diluted Equity Market Cap.: $53.36 million

Cash: $97.01 million
Total Liabilities: $7.24 million
Cash - Total Liabilities: $89.77 million
Cash - Total Liabilities / Share $3.90
Current Share Price: $2.32

As you can see, the value per share of all cash less all liabilities is 68% higher than the current share price. This situation exists for three reasons: 1.) the company is burning cash – not generating it 2.) The underlying business is perceived to be worth little or nothing at all. 3.) The management and/or the company are not proactive in releasing some of this cash value to its shareholders.

Recently, several shareholder activists have moved in into production to extract the cash value from this company that eventually, if never addressed, could find its way into failed endeavors and management’s pockets.

A group led by Steel Partners has accumulated about 1.86 million shares or about 8.2% of the basic shares outstanding. In addition, a group led by Musicmaker.com, Jewelcor Management and Barington Companies Equity Partners have accumulated at least 6.3% of the shares outstanding of LQID. Together, these two parties control at least 14.5% of the shares outstanding.

On 10/18/01 Musicmaker and others wrote a letter to LQID to request a special meeting of the shareholders so that they can elect the Chairman of Musicmaker.com (Seymour Holtzman) to fill a vacancy on the BOD, replace two directors whose term is to expire and change the corporate by-laws to allow any new directors that increase the size of the board to come only from existing shareholders.

On 10/22/01 Steel Partners made an offer to LQID to buy all the outstanding shares at $3.00/ share which was about 27% higher than where the stock was trading prior to announcement. Musicmaker has also offered to buy the company for terms at least as good as those provided by Steel Partners.

The company denied the request to call a special shareholders meeting and stated they would consider the offer at the next board meeting which they later said they were not interested in pursuing.

Musicmaker.com announced later that it intends to nominate directors to the board and make other proposals such as repealing the poison pill provision at the next annual meeting.

Several shareholder lawsuits have also been filed urging management to pursue strategies to create value and to consider the offers from the two parties mentioned above.

I believe that either 1.) management will finally give in to the relentless pressure of the various parties invested into the company and begin a liquidation or sale of the company to unlock the cash value of the company 2.) sell to either Steel Partners or Musicmaker.com for $3.00/share or higher or 3.) continue to do battle with these various parties in control for the company.

Both parties have track records in shareholder activist type situations. In fact, Jewelcor successfully wrestled away chunks of cash away from another high cash company - musicmaker.com – one of the vehicles Mr. Holtzman is using to acquire LQID.

If the company does sell to one of the parties for $3.00 or higher that will represent at least a 29% gain from today’s price. While a battle for control may rage on, the current valuation is supported by the fact that there is $3.90 in net cash per share vs a $2.32 stock price (a 66% differential). In addition, the rate of cash burn appears to be decreasing as it went from $9 million in Q2 to $6.6M in Q3 which is roughly $0.29 / share in cash. Even if cash burn doesn’t decrease for the next three quarters the company would still be left with at least $3.06 in net cash which is still 30% higher than the current stock price. While this is concerning, we have the benefit of many very motivated parties working on our behalf to bring the maximum amount of cash to us quickly. I also believe there is hidden cushion in this story the extent that the business assets and IP are actually worth anything. Every $5 million in asset value is another $0.22 in value support.

A prolonged battle may result in control of the company by our friends but may result in a liquidation scenario that could prove to be less certain than $3.00 / share but I think that given the cash cushion, more than a year could go by (not even considering the likely benefit of burn reduction) and the net cash value would still be north of the current stock price. While certain wind down costs would have to be incurred, I believe the downside is minimal and the upside good.

Positives: Decent upside potential (29%+) with attractive downside protection (high cash position bolstered by investor activism on many fronts, they are doing all the work). Asset value beyond cash can provide extra asset cushion.

Negatives: Management may pursue a wasteful acquisition or project that will burn lots of cash. Management may have the resolve to fight for an extended period of time at which point a win by us will be a less than stellar result (though not a complete zero due to the cash burn cushion).

In the end, management and the board are bound by rules that make them act in the best interest of shareholders. A slow steady burn would be obvious to all, especially amid such shareholder scrutiny, and would open up management and directors up to substantial liabilities which I believe they will try to avoid.

We are working with partners (Steel Partners and Jewelcor) who have proven successful track records in this nasty business of extracting value. Their cost basis is of Steel Partners is roughly $2.37 and I believe Jewelcor et al has a similar cost basis, so these guys have not already “made their money”. They will be fighting to make it from these levels just as we get in.

Catalyst

Catalyst: Shareholder activism resulting in the sale or liquidation of the business unlocking high cash value relative to current stock price.