NAVR II
INVESTMENT SUMMARY
Distribution of music and software is changing rapidly as a result of consolidation and the emergence of the Internet as a new distribution channel. We believe Navarre is well positioned to succeed in the changing environment for music and software distribution as it has established strong relationships with all leading retailers of music and software, and has the capability to provide fulfillment for on-line retailers. Moreover, through its strategic relationship with its subsidiary NetRadio Network, the world's largest on-demand provider of originally programmed audio content, it is an emerging player in electronic commerce, and is positioned to pursue a number of cross-marketing opportunities for Navarre's product offerings utilizing NetRadio's sales, distribution and promotional platform. A Navarre/NetRadio alliance effectively completes a complete integration of customer, product and supply chain.
Given that there is virtually no formal research available on the Street about Navarre or NetRadio, we believe the investment community does not have a good understanding of Navarre, NetRadio or the strong synergy between the two entities. Furthermore, Navarre shares have traded at prices that do not reflect the underlying value of the company's core distribution business before any consideration for NetRadio, over the past several months. Navarre has indicated that it is exploring external financing options for NetRadio, as it plans to finance NetRadio's operations independent from Navarre's in the future. We believe there is a strong possibility that Navarre will take NetRadio public, retaining a sizable ownership stake to maintain and facilitate the strategic alliance between the two companies. Given the strong performance of Internet-related stocks in recent months, NetRadio's unique strategy among on-line retailers and the synergism apparent in the relationship between the two entities, we believe Wall Street will view the outlook for both entities favorably. Consequently, we believe NetRadio will be a catalyst to add significant value to Navarre shares in the future.
COMPANY OVERVIEW
Navarre Corporation is a leading distributor of music, software and interactive CD ROM products. It is the only major distributor to distribute both music and software products. Navarre was the first national independent distributor of music, and is recognized as the leader in the distribution of independent record labels and recording artists. The company utilizes two operating divisions, music and computer products, to separately address the market for each type of product offering. Navarre's customers include every major retailer of music and software in the United States, including music specialty retailers, electronic and computer specialty retailers, mass merchants, warehouse clubs, book retailers, on-line retailers and other music distributors. Navarre's product line includes over 20,000 SKU's sold to over 500 customers with more than 10,000 locations across the United States. The company's distribution center is a state-of-the-art facility capable of drop shipping to individual retail locations or handling direct to consumer fulfillment.
Navarre has increased annual revenue at compound annual rate of 67% since 1991, despite a $4 million decline in total revenue in the March 1998 fiscal year. FY 1998 results were significantly impacted by several factors, including consolidation in the music retailing industry, and reduced credit availability from key vendors. Additionally, Navarre invested nearly $2.5 million in NetRadio during FY 98. With a more stable operating environment returning to music retailing, and sufficient working capital in place as a result of its recent $20 million convertible preferred equity offering, the company will resume its strong track record of revenue growth in FY 1999. As the company has increased annual revenue, software sales have increased much faster than music sales. Whereas in the early 1990's, when music accounted for the vast majority of the company's revenue, music accounted for about 30% of the company's revenue in FY 1998, with software generating the other 70% of revenue. The company's business plan calls for software to continue to generate most of the company's sales growth. However, the recent signing of several new independent music labels and artists should lead to strong increases in the company's music revenue in FY 1999 and FY 2000.
Navarre is also a leading content provider on the Internet through its subsidiary, NetRadio Network. Net Radio is the first Internet-only radio network and is the largest on-demand Webcaster of originally programmed audio content, with 140 channels of music and 20 channels of news and infotainment. NetRadio recently initiated its first two electronic commerce initiatives, and plans to add additional revenue sources in the near future.
MARKET OVERVIEW-MUSIC
Sales and market share by retail channel (all statistics based upon 1996 data compiled by the Recording Industry Association of America, "RIAA"). The prerecorded music industry now approaches $40.0 billion on a worldwide basis, with North America accounting for $13.0 billion. The North American market has grown at a compound annual growth rate of nearly 25% since the early 1980's. Much of the industry's growth has been generated from the introduction of the compact disc ("CD"), and consumers replacing existing music collections with the CD format. Industry growth has slowed in recent years due to a combination of factors, including fewer major releases by new artists and slower sales of catalog CD titles as consumers gradually replace music collections and the emergence of the used CD market. Another significant factor impacting retail sales has been aggressive pricing implemented by large retailers, which has resulted in lower everyday prices for many titles and forced industry consolidation. Consequently, retail sale market share attributable to the traditional mall-based music retailer has declined to about 50% in 1996 from about 72% in 1989. Many relatively small local and regional music retailers have gone out of business during the consolidation, and large mall-based retailers such as Musicland have closed stores and significantly reduced square footage. During this period, mass merchants and electronics retailers, such as Best Buy and Circuit City, have increased their share of retail sales from 16% in 1989 to around 32% in 1996. Best Buy became one of the largest music retailers by offering a much broader selection of titles (85,000 vs. 30,000 at the typical mall-based retailer) and offering new releases and other top selling titles at prices that were typically below wholesale cost. Best Buy has since rationalized its music strategy by reducing its selection of CD titles and increasing prices on new releases and top selling titles. These changes, in turn, have led to a more stable price environment, and improved operating results for mall-based music retailers.
Demographic data. The demographic profile of consumers of recorded music has changed significantly over the last ten years. The RIAA estimates that consumers under age 30 accounted about 66% of industry sales in 1986, with the remaining 33% attributable to consumers age 30 and older tend to be less "hits driven" than younger age groups and frequently purchase more than one title at a time.
Market share breakout. The five major record companies, and their affiliated distribution companies, generate approximately 80% of industry revenue. These five major labels are: Time-Warner, Sony, Seagram/MCA-Phillips/Polygram, Thorn/EMI and Bertlesmann/BMG. The remaining 20% of industry revenue is generated by record labels which are not affiliated with one of the five major record companies.
Role of independent distributors. Independent distributors perform several functions in the music industry. Most independent distributors function as supply sources for accounts (typically small music retailers) that the major record labels will not sell to, or music retailers that do not want to purchase directly from the major record companies. These distributors may also function as supply sources for larger retailers on a temporary-out-of-stock basis. Some independent distributors focus much of their business efforts on representing independent record labels and recording artists. Navarre considers itself a "one-stop" independent distributor in that while it focuses heavily on distributing independent labels and artists on an exclusive basis, it also functions as a supply source for a broad range of music retailers.
Emergence of the Internet as an alternative distribution channel. The most significant dynamic that will impact music industry distribution in the future is the emergence of the Internet as an alternative retail channel. The Internet's impact on music distribution has been minimal to date, accounting for just $35 million of 1997 revenue. However, Jupiter Communications, a market research firm, estimates that on-line music sales will grow to $1.1 billion in the year 2002. Key factors sited by Jupiter that will drive growth of on-line music sales include:
Music's low price point and very broad demographic appeal are well suited for electronic commerce.
On-line retailers provide greater convenience and selection (over 250,000 titles to choose from on www.cdpoint.com compared to fewer than 30,000 at most music retail stores) for consumers.
The multimedia features available through the Internet (audio, video and graphics) make it an ideal medium to market and sell music, enabling consumers to preview a potential purchase, and should create greater impulse buying and positively impact the overall size and growth rate of the music industry.
About $540 million, or 18% of 1996 North American retail music sales were made through direct marketing channels such as music clubs and catalogs, which suggests that consumers are comfortable with purchasing music from alternative retail channels. Furthermore, on-line music retailers can access the entire world, rather than remain confined to North America. About 25% of music purchased on-line in 1997 went outside the North American market.
In terms of households, Jupiter estimates that about 400,000 households made on-line music purchases in 1996. It expects the number of households making on-line music purchases to increase to 6 million in 2000 and 16 million in 2002.
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