RealNetworks (“RNWK”) RealNetworks is a $334MM market cap company with a total enterprise value of approximately zero, some valuable assets, and catalysts which may trigger a significant increase in shareholder value. Their collection of businesses are at best stagnant and at worse declining (thus the zero TEV), but they are not bleeding cash despite heavy R&D and overhead spending. 34.5MM sh out $9.40/sh $325MM equity cap -305MM cash (after recently closed $120MM patent sale to Intel) $20MM TEV (plus they have assets held for sale of $40mm, which are comprised of small stakes in publicly traded entities in Korea and Japan, so TEV is actually slightly negative including this).

The Company is a former internet high flyer which was founded by Rob Glaser, who still controls the company with his 38% ownership, but is no longer involved in day to day operations. The current mix of businesses are not very interesting, and are certainly not growing, but there are not many stocks out there (other than biotechs burning cash) which can trade for a zero enterprise value but are not burning cash and have significant value. Revenues per share are almost $10. Thomas Nielsen was named CEO in November 2011 (the 4th CEO since January 2010 when Glaser stepped down). Nielsen is a former Adobe executive who ran the Photoshop division, and has a stated commitment to make major changes at RNWK.

The Businesses

RNWK has 3 reporting segments, plus an unconsolidated 47% ownership in Rhapsody, a music streaming business.

1) Core: $191.2MM of 2011 Revenues, $43.2mm of EBITD and is a bit of a hodgepodge. Down 10.2% in 2011 and down 7.5% in 2010.

$119mm (62%) is “SaaS”: services sold to 90 different mobile carriers (the largest of which are SK Telecom of Korea and Verizon). The services include ring-back tone (RBT) (in which callers hear music or celebrity messages instead of a ringing sound while waiting), music on demand, and video on demand (MOD, VOD) for mobile phones, which allows mobile subs to download or stream music or video, and inter-carrier messaging (ICM) which routes SMS messages between different wireless carrier networks under partnership with Syniverse. It is believed that ICM is profitable, RBT is somewhat profitable and VOD/MOD are not. The SaaS business is declining ($119.3mm in 2011, vs $133.5mm in 2010, down 10.6%) due to both pricing pressure and increasing use of smartphones which have their own apps to take the place of the SaaS services.

$6.8mm of Core (3.5%) is systems integration, which is about flat with 2010, and is probably breakeven.

$28.4mm (14.9%) is Helix Software Licensing which allow companies to broadcast live and on demand audio, video and multimedia to large numbers of simultaneous users over the Internet. Helix is also licensed to mobile network operators and handset manufacturers, with agreements to preinstall the Helix mobile media player software on mobile phones. Licensing revenue is down 7% vs. 2010, but Helix (like most licensing businesses) is believed to be very profitable.

$36.6mm (19%) of Core is SuperPass, http://www.real.com/superpass

a subscription based service which allow consumers to access live video feeds from the Big Brother program and other content. (Why someone would want to do this, I don’t know!). SuperPass revenue is down 12% from 2010 but is believed to be very profitable.

2) Emerging reported $46.6mm of Revenue and -0.2MM of EBITD in 2011, but the lack of profitability is misleading. 100% of the Emerging segment revenue is from RealPlayer (but not 100% of expenses). http://www.real.com/

RealPlayer media software allows consumers to play, download, manage and edit digital video. It is available for free download, and the premium version is available for enhanced functionality. RealPlayer is monetized with revenue from the premium version, and from distribution of 3rd party software such as Google toolbar and Google chrome to consumers who are downloading RealPlayer for free (InteractiveCorp “IACI” is very successful at this type of thing). RealPlayer’s dominant competitor is Windows Media Player (available for free download from Microsoft). RealPlayer’s revenues were actually up 11% in 2011 but profitability was down. RealPlayer is very profitable – gross margins are estimated at 75-80% - so why is Emerging breakeven?

Because RNWK was attempting to launch Unifi, a personal media cloud service to organize and access content from any device. However, everyone and his brother decided to do the same thing (with deeper pockets) in 2011 including iCloud, Amazon Cloud Drive, Google Music Beta, Microsoft SkyDrive) and RNWK is now reevaluating Unifi.

3) Games (GameHouse) $97.9mm revenue, $9.2mm EBITD http://www.gamehouse.com/

2011 Revenues were down 12%, but EBITD was flat with 2010. 2010 was down 9%. This segment was traditionally PC games, which are clearly in secular decline. RNWK is attempting to transition from a download model to social games which are monetized by advertising and/or microtransactions. GameHouse has been traditionally focused on casual and puzzle-type games such as UNO, Scrabble, Collapse and Bayou Blast. The social piece is growing rapidly but it has been slow to monetize.

4) 47% ownership of Rhapsody http://www.rhapsody.com

Rhapsody enables consumers to have unlimited access to digital music (14mm songs) from a variety of devices. For $10/mth, you get access on 1 mobile device, online streaming, unlimited home audio listening, and for $15/mth you get access on 3 mobile devices, online streaming and unlimited home listening. Subscribers can search and browse, create playlists, play a Rhapsody “radio station” based on a specific artist or genre (like Pandora) without ads, and music can be shared with other Rhapsody users and saved in a library. Total Rhapsody Revenues in 2011 were $127MM, and it had a $13.6mm operating loss. However, Nielsen said on the February 2012 earnings call that it is approaching breakeven with over 1mm paying subs. Note that Pandora, which is more of an advertising model, has 80mm users but not much more revenue than Rhapsody at $137mm in 2011, but an equity cap of $1.4B even after the recent blowup. Spotify, which is still private, is a much closer comp in terms of business model and probably has 2.5mm subs but similar Revenues (the lowest tier is only $5/mth). Rhapsody was deconsolidated in March 2010 and is now 47% owned by RNWK, Viacom owns about the same, Best Buy (which sold Napster to Rhapsody) has a few percent, and another individual owns 1%.

Why is this remotely interesting and what are the catalysts? There are some clear and obvious negatives to this story (almost every business is declining, which is why it is so cheap!) but there are some significant positives as well. First, the new CEO seems very committed to shaking things up. Let’s look at some extended quotes from the February 2012 earnings call:

“I think it’s clear the status quo is no longer an option.” “…Let me acknowledge that many of you have seen this movie before and you’re likely a bit skeptical and asking yourself what’s different this go-round? What I think we can offer you are the following. First, the Chairman (Glaser) and board selected me for this job, as the Company’s first outside CEO and as a change agent who they believe can successfully transform the business. Second, I have a very strong sense of urgency about both defining … RealNetworks, as well as simplifying, focusing and unlocking value from existing businesses. If a business is not making money and growing, it’s not going to fit into the profile of RealNetworks version 2 and we’ll quickly decide…what ultimately creates the best value for our shareholders.” “We have to narrow our focus on monetizing those assets that are not strategic to us going forward. And we’ll take a hard look at businesses that don’t fit the growth profile we’re looking for, whether we sell those businesses, spin them off in a Rhapsody type deal, or manage them for maximum cash flow to the natural end.” “We’ve already started to carve-out our SaaS business from our consumer businesses and explore strategic alternatives.” “On top of the simplification we’re already pursuing, we need to make a few big bets, something that resembles more of a 90 degree turn for RealNetworks.” “We’re not ready to share the broad roadmap of where we’re going as a company. But suffice it to say that I want to leverage RealNetwork’s core assets to capitalize on the huge and growing universe of digital content that’s been created, distributed and now starting to be monetized. “ “We’re exploring a variety of acquisitions and divestitures…We’re exploring opportunities that exhibit…growth profile of 20% compound annual growth rate in a growing multi-billion dollar market, a worldwide profile that can leverage RealNetwork’s global footprint, and a strong product customer and marketing DNA. It’s likely that we won’t do one huge transaction.”

OK, so what does all that mean? I’m not sure which of their businesses fits their definition of being a “keeper”. Maybe none. But it seems that the core idea behind the company involves the ability for consumers and businesses to manipulate audio and video content. That would imply that Helix, RealPlayer and SuperPass are keepers. SaaS is clearly the most likely near-term divestiture candidate. It is unclear where Games fits in, but they probably would like to first get some traction in social games before spinning or monetizing it. It is unlikely they can compete against Apple, Microsoft, Google and Amazon with their Unifi offering. It is unclear whether Rhapsody will be worth anything, but it is clearly non-core and it may make sense to merge Rhapsody with Spotify in exchange for stock in a future Spotify IPO (the idea being that Spotify could transition 1mm Rhapsody subs onto their own platform, essentially paying Rhapsody for its installed base, not for its business).

I think it’s important to recognize that RNWK spent $55mm on corporate overhead and $70mm on R&D in 2011.  Over the past 5 years, they have averaged over $100mm per year in R&D expenses. The company has a $330mm market cap, with a zero total enterprise value, and not much more than breakeven EBITD. However, although the individual business units are unexciting or worse, there is profitability, primarily from licensing businesses, which is being hidden by all of the R&D spending. They are clearly going to shake things up – some businesses will be sold, and they will not be returning cash to shareholders, but they are likely to use it for acquisitions. However, it seems highly likely that they will be divesting before they buy. They already acknowledge that they have way too many businesses to manage as it is, and they need to reduce the complexity. From a “stock trading” standpoint, as I mentioned above, there are not many non-cash burning businesses with $10/sh in Revenues (not including Rhapsody) which trade for zero total enterprise value, and if the next event is they sell SaaS for say, $2/sh, then the stock must rise by $2 or else we are now looking at negative TEV, which is even more uncommon.

The stock price is essentially predicting that either almost $10/sh in Revenues (not including Rhapsody) is worth zero, or that management is going to (continue to) destroy value. I think there clearly is value in those revenues, but the ability of management to avoid burning through that value is certainly debatable. THIS IS THE KEY ISSUE! I don’t think there is any question that a value maximizing owner of RNWK could significantly increase shareholder value, but it is still an open question whether THIS management can and will do that. We don’t know what this company will look like in two or three years. It is almost certainly going to look quite different.

Just as a theoretical exercise, what might it be worth right now in a liquidation (which will never happen)?

SaaS - $119mm Revenues, unclear profitability, value at 50% of Rev - $60mm

Helix licensing – $28.4mm Revenue, highly profitable, 3x Revenue - $84mm

RealPlayer - $47mm Revenue, very profitable, value at 1x Revenue - $47mm

Games $98mm Revenue, $9.2mm EBITD- value at $50mm

Unifi cloud sharing – value at zero, but maybe there is some IP value

SuperPass - $36.6mm Rev, very profitable, value at 1x Rev - $37mm

Rhapsody – guesstimate $47mm for their share (100mm for 100%)

Total value - $325mm or $9/sh Since TEV with the stock at $9.40 is zero, this values RNWK at $18.40, up 92%. I wouldn’t take these numbers too seriously because they aren’t liquidating and we are dealing with a lot of guesswork on profitability and valuation. But the takeaway should be that it is being valued for zero and it is significantly more than zero. FINANCIALS Note that Core was profitable. Emerging was about breakeven, but that was because of spending on Unifi – the revenues are all Realplayer which is profitable. Games was profitable. Corporate expense is huge. In addition, Rhapsody was $127.2MM revenues, and $13.6mm operating loss, for 100% of the business (RNWK owns 47%). CONCLUSION RNWK is trading as if the businesses are worth zero, and they are worth a lot more than zero. There is almost $10/sh in Revenues (not including Rhapsody) and some of that revenue although unexciting is very profitable (Realplayer, Helix, Superpass). Management seems extremely focused on change and increasing value. The key bet here is that they are going to both sell and buy, and if you buy stock, you are willing to give management some benefit of the doubt that they will not destroy value with dumb acquisitions. Although this is a leap of faith, I think it is cheap enough (“free”) to be willing to take that risk.