Hi, here's an article... Real Networks

**FutureHFGuy** Fri Mar 03, 2006 10:34 pm

Hi, here's an article... Real Networks
Hello,
I enjoy reading these boards and I finally decided to post one of my articles. All my articles are available on my blog (www.marketmoney.blogspot.com) and my website (www.marketmoneyletter.com). Hope you enjoy!
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Real Networks is a company I purchased Monday for my public real money portfolio. I believe this company is significantly undervalued and I am taking action. Below I have outlined my premise for this “undervaluation” call.

Premise:
Real Networks has become significantly undervalued due to a recent win against Microsoft. Although the stock was bid up following their win against Microsoft, the stock hasn’t moved much since the win. The balance sheet is in excellent condition and will only get better and concerns about the underlying business are priced into the stock.

The company currently has $781 million in cash and $100 million in debt. I expect the cash balance to increase, as Microsoft is to pay another $300 million over the next year or so (either in cash or subscribers). As a result, RNWK will be sitting on roughly $1 billion in net cash while it carries a mere $1.3 billion market cap. This leaves us with a roughly $300 million enterprise value.

Next, I find the TTM structural free cash flow/owner earnings (defined as net income + depreciation + amortization – capital expenditures). I have made numerous adjustments to the income and cash flow statements to “normalize” the results. First, I have backed out all interest gains (as I have backed out the cash to find the enterprise value). Next, I have added $12 million back (in order to adjust for the amount of legal fees they have been paying yearly in the case against Microsoft), which they will no longer need to pay. I have found adjusted owner earnings over the TTM to be $20 million. This represents an EV/FCF yield of 7%. While this isn’t “dirt cheap” I believe this company has solid growth ahead of it.

I believe the growth drivers in coming quarters in years are the company’s online music and gaming platforms. While iTunes is currently dominating the online music space, Real Networks is a solid second and I see no reason to believe they can’t take market share from iTunes. Although their model is different than that of iTunes (renting vs. buying music), I believe each model has its benefits. Also, the company’s online gaming platform has, in no way, reached its full potential.

Lastly, at $300 million in enterprise value, the company is trading at less than 1x TTM sales of $332 million. Furthermore, analysts expect revenues of $373 million for the year ending in December 2006, and $430 million for the year ending in December of 2007. Assuming they meet analyst estimates for 2007, the company is only trading at .7x future sales.

In conclusion, while this company is hard to value on a cash flow basis due to its confusing earnings in recent years requiring adjustments, I believe this company is undervalued. I don’t think the street has priced this stock efficiently, especially when considering the growth outlook on the online music and gaming space, as well as the numerous benefits of the Microsoft win.
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Hope to win! :D

**blast_investor** Fri Mar 03, 2006 10:46 pm

Hi FutureHFGuy:

Very good write up on Real Network.

I have a valuation question on real network. You mentioned "EV/FCF yield of 7%" as cheap, Do you have any peers valuation comparison on this EV/FCF yield?

**FutureHFGuy** Fri Mar 03, 2006 11:00 pm

Hi Blast,
That is a very valid question. However, I don't think there are any fair competitors that trade publically. They are #2, only behind AAPL. But, Apple's company is way too large and diversified to use as a comparison.

Any thoughts on how you would value it?

Thanks,
Kevin

**blast_investor** Fri Mar 03, 2006 11:45 pm

I still do not know that much in this sector.

The quesiton of competition against AAPL. Apple is mainly into selling songs with iPod and iTune while RNWK is trying to rent the music. The market seems to say that people are going to buy the songs, not rent it. Only cashual music fans would rent the songs.

Do you have any sense of potential market for renting songs? Do you believe RNWK can survive the competition from Apple?

**FutureHFGuy** Sat Mar 04, 2006 12:10 am

I do believe RNWK can survive against AAPL for a few reasons:
-their balance sheet is stellar so if times get really tough they aren't going anywhere fast, financially
-competition especially in a low margin-high volume business such as online music is fierce. That said, the company still boasts #2 market share in this space, and I think they stand to benefit as Apple begins to slow down. Why will Apple slow down? Because they have brilliantly integrated the iPod and iTunes to become one product. As the iPod reaches critical mass, I expect RNWK to be able to take market share from Apple because the rent model is certainly more economic for many consumers.

It is also important not to discount the value of RealNetwork's other brands -- i/e online gaming and online video. Both still have plenty of potential, and I believe once these products start to live out their expectations RealNetwork's music downloading system stands to benefit as they integrate the product line (similar to what Apple has done).

I understand your concerns about competition but I that’s why I focus on tech companies with low valuations, pristine balance sheets, or incredible management teams.

**vin** Thu Mar 09, 2006 5:16 pm

Is real network with 300M?
Good story on cash and sales growth story. But I can not find out if real networks worth 300M (assume real network recieve all the cash from MSFT including lawyer fee, which is 1 billion total), given revenue of 300M/year and operation income is basically zero in the last few years.

**springsnailt** Thu Mar 09, 2006 5:41 pm

The income record of RWNK has been miserable in the past a few years. The worse problem is, it doesn't seem like RWNK has any chance competing with AAPL in online music downloading.

Let's face it:

1. RWNK is awkwardly positioned. Its target consumers may not exist in the first place. People who use AAPL are more service sensitive and less price sensitive. The ease of downloading illegal music over the internet will take away those who are extremely price sensitive. So what's left in between for RWNK is not much, if at all.

2. AAPL's strategy to promote software sales through introducing cool hardware gives it a strong competitive edge. It's so convenient to use iPod+iTunes together. Considering the market share of iPod, the loyal customer group for AAPL is extremely large.

So the conclusion I'd like to draw is: RWNK deserves its low valuation, and I don't see the future of its business.

**vin** Fri Mar 10, 2006 11:52 am

It is very hard to value a company have 0 operation income for years. I post comments on COMS in this forum last few months. Basically, market value coms ( a comany with 600M revenue and zero opreation income )for 0 until 11/05. Now, market price COMS for 300M( for its 600M revenue & growth & 0 profit ). So I do not think RNWK worth 300M (at 300M sale&growth& 0 profit). Not cheap enough.