Part IV
GROWTH STRATEGY
Navarre has established a strong platform to facilitate sales growth in its core music and computer products business, as well as launch its entry into electronic commerce with NetRadio. Limited equity, industry consolidation and the capital required to develop NetRadio have constrained Navarre's sales growth over the last two years. With the recent completion of a $20 million convertible preferred equity offering, the company has sufficient working capital to support a substantial sales growth. Over the next several quarters, we believe Navarre will accomplish the following objectives that should lead to strong sales growth:
Expand share of distributed personal computer software market. Over the past two years, Navarre has focused on developing NetRadio and managing its balance sheet while many customers went out of business. Consequently, it did not have sufficient working capital to expand its software distribution business. With the completion of its $20 million convertible preferred equity offering, Navarre now has the financial resources to aggressively expand its share of the distributed personal computer software market. The company plans to begin shipping product for new software publishers, and begin distributing additional product for existing customers, in the near future. Additionally, Navarre has indicated that it will expand its relationships with key retailers, particularly in the electronic commerce and office superstore categories, effectively replacing other supply sources that these retailers have been utilizing. Navarre recently became a strategic supplier of consumer software to Barnes & Noble bookstores, and its' on-line retailer, barnes&noble.com.
Add new independent music artists. Over the last three years, Navarre has gradually expanded its independent music distribution operations by entering into exclusive distribution agreements with artists across all genres of music. Significant artists and labels which have been added recently include Kenny Rogers, Celestial Breakaway (which includes Nate Dogg and Snoop Doggy Dogg) and an expanded agreement with American Gramaphone (Mannheim Steamroller). The company has indicated that additional gold and platinum recording artists will be added in the near future. Navarre now generates close to 30% of all Christmas music sales with its independent artists and labels. Consequently, Navarre's music revenue should increase in the future after two years of flat revenue.
Utilize its distribution platform to add DVD to its product offerings. Navarre will utilize its existing customer relationships and field merchandising expertise to begin distribution Digital Versatile Disc products. While industry-wide DVD sales are not significant at this point, trade sources predict that DVD software sales will increase rapidly over the next several years because DVD hardware sales have been strong in recent months. Navarre will begin shipping DVD products in the near future.
Launch NetRadio into electronic commerce. NetRadio's content enabled strategy (explained later in the report) focuses on utilizing compelling content to create a large audience of repeat listeners that can be used as a marketing platform to pursue a wide range of commerce and revenue generating opportunities. NetRadio is generating 20 million page views per month, and almost 3 million audio visits per month, with an average audio visit lasting almost 30 minutes. NetRadio recently introduced its initial two electronic commerce initiatives, CDPoint (http://www.cdpoint.com), which offers over 250,000 CD titles and SoftwarePoint (http://www.softwarepoint.com), which offers 6,500 software titles.
Establish a Navarre/NetRadio strategic alliance which creates a complete integration of customer, product and supply chain. Navarre will provide much of the product fulfillment required by NetRadio's electronic commerce initiatives. Consequently, an alliance between the two entities should be very synergistic, enabling NetRadio to utilize Navarre's infrastructure to leverage its sales, distribution and promotional capabilities. The alliance may also provide Navarre with the marketing and distribution platform to facilitate new proprietary music opportunities in the near future.
NETRADIO
Overview. NetRadio was the first Internet-only audio content provider when it began broadcasting on November 1, 1995. It has since evolved into the largest provider of original audio programming on the Internet, broadcasting over 140 channels of music and 20 channels of news and entertainment, all free to intent users at (htttp://www.netradio.net). All content is delivered on a live basis, 24 hours per day, seven days per week. NetRadio develops its own content utilizing an experienced staff of music programmers and disc jockeys. Listeners typically tune into NetRadio while surfing the Internet or working on applications. NetRadio's 140 channels of music is categorized into 14 broad genres of music. Within each genre, listeners can select a channel that best suits their individual music taste. For example, instead of settling for a generic jazz station, listeners may chose between 12 distinct jazz channels, including Big Band, Crooners, Acid Jazz, Contemporary Jazz and Jazz Artist of the Month. NetRadio's goal in offering a broad range of choices is to appeal to any taste, age or demographic. Consequently, while NetRadio strives to attract a large overall audience, it also strives to be able to reach audience segments that are narrowly focused within very specific listening tastes. With its broad selection and continuous 24 hour format, NetRadio can provide virtually any listener with exactly what they want to hear, whenever they want to hear it. Integrated into NetRadio's audio stream are audio ads, liners and product recommendations, enabling NetRadio to leverage the listener into a variety of revenue generating possibilities. NetRadio was awarded the 1998 "NetSquak" Streamers Award for the best real audio net-only radio station by RealNetworks, the pioneer and market- leading provider of real-time media over the Internet.
Traffic. Currently, NetRadio generates about 20 million page views per month, or close to 1 million visits per day. Almost 3 million audio sessions per month are being generated, with an average listening time just under 30 minutes. I/PRO. A division of Nielsen Research, estimates that 73% of all first time visitors to NetRadio make return visits. Furthermore, NetRadio's traffic has increased at a rate of 8% per week since mid-1997 and the first half of 1998. These traffic statistics have been generated without significant payments to other content providers or on-line service companies. However, NetRadio is linked to 15,000 other websites around the world. In comparison, other major companies (primarily CDnow and N2K) that market and sell music over the Internet are generating higher traffic statistics (150,000+ page visits per day), but have also paid substantial dollars to place advertising and set up links with on-line service and content providers. NetRadio recently commenced a major strategic initiative that should significantly increase traffic by launching Net Media Player, a uniquely designed radio, which will appear exclusively on the Window 98 desktops of al new Packard Bell and NEC Ready computers. Net Media Player will feature 35 NetRadio channels. Assuming that Navarre completes a financing for NetRadio (discussed later in this section), we would expect that NetRadio would utilize much of the proceeds to improve and increase its marketing efforts.
Vision and Strategy. NetRadio's strategy focuses on integrating content and commerce into a package it has named "content-enabled commerce". NetRadio is attempting to develop a content-driven platform that effectively generates a large audience of repeat listeners which serves as a marketing platform for a wide variety of commercial and revenue opportunities. In comparison, most on-line music retailers are focusing on sell-through of product by accessing traffic through aggregators or other content providers. By integrating content and commerce, NetRadio effectively differentiates itself from other on-line music retailers several different ways:
Reduced cost of customer acquisition. NetRadio utilizes proprietary content to attract users rather than paying substantial dollars to aggregators or content providers to attract users. To date, NetRadio has spent virtually no marketing dollars to generate traffic. NetRadio's content has also proven highly effective at generating repeat visits. In comparison, NetRadio estimates that on-line music retailers N2K and CDnow have paid over $100 million to establish alliances with other Internet entities aimed at generating traffic.
Significantly lower break-even point. NetRadio's operating costs are significantly lower than N2K's and CDnow's, due largely to its strategy of utilizing proprietary content rather than paying substantial amounts of money to aggregators to generate traffic. Consequently, NetRadio believes it can achieve profitability at a revenue run-rate well below $100 million whereas the business model of competitors requires hundreds of millions of revenue to achieve profitability.
Create multiple sources. NetRadio plans to generate revenue from many sources. It recently introduces CDPoint and SoftwarePoint, which offers consumers 250,000+ CD titles and 6,500 software titles, respectively. NetRadio plans to work closely with Navarre to add other product offerings in the future. Other future sources of revenue include the integration of revenue-generating audio streams such as audio ads, liners and product recommendations. Because NetRadio's content driven format will drive more frequent visits to its website, it will likely prove to be effective at creating impulse purchases. The value of a single customer visit will effectively be multiplied by forwarding a listener or customer to additional revenue sources once these sources have been established.
More efficient fulfillment through alliance with Navarre. NetRadio anticipates utilizing Navarre to fulfill as much as 50% of its music and software volume, effectively accessing this product at lower prices than other on-line music retailers which utilize Valley Distribution or other third parties for their product fulfillment requirements. Consequently, NetRadio will generate higher profit margins than competitors. NetRadio has also established a strategic alliance with Value Vision, America's third largest home shopping network, to provide expertise in warehousing and distribution of product sold over NetRadio's website.
Positioned for convergence of the Internet, computer and home entertainment. With its wide range of music content, NetRadio is well positioned to become the media content of choice as more households upgrade technology and can utilize the Internet for home entertainment purposes.
Introduction of content-enabled commerce offerings. NetRadio recently introduced its initial electronic commerce initiatives, CDPoint (http://www.cdpoint.com) and SoftwarePoint (http://www.softwarepoint.com). Both sites are linked directly to NetRadio, enabling every NetRadio listener easy access to over 250,000 CD titles and 6,500 software titles. Both websites incorporate a state-of-the art shopping basket that, along with the search engine, stays with the consumer at all times, effectively reducing the number of clicks and time required to make a purchase. Purchases can be made while listening to NetRadio, or by listening to product previews, and simply clicking a mouse to complete the purchase. By making the shopping experience as simple as "listen, click and purchase", NetRadio has created an easier and more user-friendly shopping experience and created an environment where the shopper is more likely to make impulse purchases. In comparison, competitor's shopping baskets require the consumer to move backwards during the shopping experience to look for additional titles and complete an order. By combining its 160 channels of programming with its listen, click and purchase technology, NetRadio can target promotions at highly segmented audiences and capture the impulse purchase power inherent in listening to any one of the channels, by enabling the audiences to purchase the titles they are listening to while they are listening to them. For example, if you are listening to any one of NetRadio's Jazz channels, you will be informed about special offers on Jazz CD's from CDPoint, or if you are listening to the KidsRadio channel, you will be informed about special offers on a number of educational software titles from SoftwarePoint. This capability, combined with the audience segmentation which occurs as a result of NetRadio's 160 channels of programming, will enable NetRadio to work closely with record companies, software publishers and other potential advertisers to promote product, creating additional revenue streams for NetRadio. NetRadio introduced CDPoint in mid-June and SoftwarePoint in late-June, and is now generating 5,000 to 10,000 visits a day to the two websites.
Cross- marketing opportunities with Navarre. Navarre can utilize NetRadio's marketing, promotion and distribution capabilities to increase sales of its product offerings and provide it with an important asset in expanding its proprietary product offerings by becoming a more attractive distribution vehicle for independent music artists and labels.
Outlook. NetRadio plans to focus most of its efforts over the near term on executing its business plan of building a large audience of regular listeners and using the audience to launch various commerce and revenue initiatives. While NetRadio has only started generating revenue recently, its business plan has been developed with the objective of minimizing customer acquisition costs and product fulfillment-related expenses. Consequently, we believe NetRadio will be able to operate profitably on significantly lower revenue volumes than competitors whose business models are predicated on significant marketing outlays to generate traffic. We believe it will take NetRadio two-to-three years to achieve a profitable level of revenue. Over the next year, we believe NetRadio may add new product categories, such as DVD, and begin generating other forms of revenue besides product sales, such as advertising or sponsorship related revenue.
From the standpoint of Navarre shareholders, we believe NetRadio will be a catalyst to move Navarre share prices higher over the remainder of 1998. Navarre has indicated that it is evaluating various external financing options for NetRadio, as it intends to finance NetRadio's operations independent of Navarre's. We believe there is a strong possibility that Navarre will take NetRadio public, retaining a significant ownership stake in it to maintain and facilitate a strategic alliance between the two entities. Given the recent strong performance of Internet-related stocks, NetRadio's unique strategy among on-line retailers and the synergism apparent in its relationship with Navarre, we believe Wall Street will view the outlook for NetRadio, and its strategic alliance with Navarre, favorably. Consequently, a sizable retained interest in a publicly-traded NetRadio should add meaningful value to Navarre shares and act as a catalyst to move them much higher.
MANAGEMENT
Navarre's management team is led by Chief Executive Officer Eric Paulson and Executive Vice President, Chief Financial Officer Chuck Cheney. Mr. Paulson founded Navarre in 1983 after leaving Pickwick International, where he was a SVP and GM Pickwick Distribution Companies. Mr. Paulson was an EVP and COO of Lieberman Enterprises, Inc. in 1990 and 1991, a period when Lieberman and Live Entertainment, Inc. owned Navarre. Mr. Cheney has been the CFO of Navarre since 1983, and was a Senior Vice President of Lieberman Enterprises when it owned Navarre in 1990 and 1991. Mr. Cheney is a CPA. Other members of Navarre's senior management team include: Guy Marsala, COO; Terri Bonoff, VP & GM, Computer Products: Tom Lenaghan, VP & GM, Alternative Retail Marketing: and John Turner, VP, Operations.
NetRadio's management team has been in place since early 1997 and have designed its content-enabled electronic commerce strategy. NetRadio's senior management team is led by Donovan Pederson, COO; Jan Anderson, SVP of Sales and Marketing; and David Witzig, VP of Content and Commerce Development. Mr. Paulson and Mr. Cheney have been serving as the CEO and CFO, respectively, of NetRadio.
FINANCIAL
General. Our earnings model assumes that Navarre sells at least 50% of NetRadio to the public sometime during the third (December) quarter of FY 99. Subsequent to a public offering of at least 50% of NetRadio, Navarre would not have to consolidate NetRadio's operating results for financial reporting purposes. Consequently, our FY 99 earnings model assumes that NetRadio's operating results are included in first and second quarter operating results, and not included in third and fourth quarter operating results. Consequently, we have assumed lower levels of operating expenses in our projected operating results in the third and fourth quarters. If Navarre does not sell at least 50% of NetRadio to the public, it will include NetRadio's operating results in its income statement for the entire year, likely resulting in higher expense levels in the third and fourth quarter than we have projected.
Revenue. Our projected revenue increase of 43% to $281.0 million in FY 1999 is driven by growth in both software and music, and the addition of DVD video to Navarre's product offering. Software revenue growth will be generated by expanded relationships with existing retail customers and the addition of barnes&noble.com. Music sales growth will be generated by the addition of new independent artists and labels, as well as the alliance with NetRadio. We expect revenue growth in FY 2000 to continue to be generated by the same factors, and project a 27% increase to $355.5 million. Navarre's business is seasonal in nature due to the holiday sales season. Consequently, the company's third quarter, which ends December, it its highest revenue quarter of the fiscal year.
Gross Margins. We are projecting a slight decline in gross profit margins in FY 99 to 12.3% from 12.7% in FY 98. Gross profit margins are driven by sales mix, and to some extent, terms from software publishers. Given that the company now has a much stronger working capital position, we expect it to receive better terms from software publishers in the future. Additionally, we expect a meaningful increase in Navarre's proprietary music revenue, which generates much higher gross profit margins than major record label or software product revenue. Consequently, there may be some upside for gross margins relative to our projection assumptions.
Operating Margins. We are projecting a significant improvement in operating margins from 0.7% in FY 98 to 3.0% in FY 99, driven largely by leveraging general and administrative expenses. Navarre has the management team, staff and information systems in place to grow revenue to $500 million without significant headcount additions or significant outlays for information systems. We estimate that FY 99 operating expenses would be approximately $1.0 to $1.2 million lower if NetRadio was not consolidated in first and second quarter operating results.
Interest Expense. We expect a significant reduction in interest expense as Navarre has initially utilized the proceeds from its recent $20 million convertible preferred equity offering to pay down its revolving line-of-credit, which is utilized to support its working capital needs, and negotiate improved credit terms with its lender. Additionally, Navarre is no longer experiencing any delays in collecting receivable from key customers. Consequently, we do not expect the company to utilize its credit line to the extent that it has the last two years, over the next two years, resulting in a significant reduction in interest expense.
Net Income. As discussed above, we have assumed that NetRadio's operating results are consolidated into Navarre's operating results in the first and second quarter, and not consolidated in the third and fourth quarters. We believe that Navarre's net income for FY 99 would be approximately $600 to $720 thousand higher (or $0.05 on a fully-diluted EPS basis) if NetRadio's operating results were not consolidated into Navarre's first and second quarter results.
S
Shares outstanding and EPS. As of early July, Navarre had about 7.2 million common shares outstanding. The number of common shares outstanding will increase as a result of the company's convertible preferred equity offering which was completed in May, raising $20 million of new equity. The company issued 1,523,810 shares of preferred stock, each share convertible into 5 shares of common stock, or approximately 7.6 million new common shares. The preferred shares pay a dividend of 10% that accrues from May 1, 1998 until the date they are converted, payable on a quarterly basis. Preferred shareholders can convert their preferred shares at any time after June 30, 1998. The preferred shares also include a warrant to purchase 5 shares of Navarre common stock at $3.50 per share over a 5 year period. Navarre can call 50% of the warrants after 1 year if the bid price for Navarre equals or exceeds $5.00 for 10 consecutive trading days. Navarre can call 100% of the warrants after 2 years if the bid price for Navarre equals or exceeds $7.50 for 10 consecutive trading days. Consequently, up to an additional 7.6 million shares of common may be issued over time. For projection purposes, we have assumed conversion of the preferred shares into an additional 7.6 million shares outstanding, but have not assumed exercise of any warrants. Therefore, it is possible that the fully diluted number of shares outstanding may increase beyond the 14.87 million and 15.02 million fully diluted shares outstanding assumptions utilized in our FY 99 and FY 00 EPS estimates, respectively. We have projected EPS on a primary basis, which incorporates a deduction of preferred dividends from net income and assumes no conversion of common shares for EPS purposes. Additionally, we have projected EPS on a fully diluted basis which assumes conversion of the preferred shares (but no warrants being exercised) and no deduction of preferred dividends from net income. Our fully diluted EPS estimates are $0.26 and $0.43 for FY 99 and FY 00, respectively. Excluding the impact of NetRadio on FY 99 operating results, we estimate that Navarre would generate fully-diluted EPS of about $0.30 in FY 99.
Balance Sheet. Navarre's balance sheet is now very solid, with about $98.4 million of total assets, $23.3 million of equity and no long-term debt. Current assets approximate $96 million (including $56 million of accounts receivable and $27 million of inventory) while current liabilities approximate $74.5 million. As of early July, Navarre's revolving line-of-credit approximated $18 million; total availability on Navarre's revolving line-of-credit approaches $40 million. Navarre regularly uses most of its cash to pay down its revolving line of credit to minimize interest expense.
VALUATION
We believe Navarre should be valued giving consideration for both the earnings of its core distribution business and its interest in NetRadio. On an earnings basis, we believe a reasonable valuation is about 20 times projected FY 99 earnings (or $0.30, which excludes the impact of consolidating NetRadio's operating results in the first and second quarter), or $6 to $7, before any consideration for Navarre's stake in NetRadio. We believe a multiple of 20 times EPS is warranted by Navarre's strong revenue and earnings growth. This valuation assumption also implies that Navarre shares will be valued at a significant discount to the anticipated growth rate of net income and EPS in FY 99 and FY 00. Valuing NetRadio is less straight forward as we believe that a market valuation of NetRadio will be driven largely by the market environment for Internet-related stocks. However, we believe that a successful public offering of NetRadio would result in a post-offering value of at least $100 million (or about one-third the value of the closet public comparable, CDnow and N2K). Consequently, we believe a publicly-trade NetRadio in should add at least an additional $2 to $3 per share in market value to Navarre shares implying a reasonable price target of $8 to $10 over the next 3 to 6 months, with the potential for significant upside from this range. Navarre shares have spent most of the year trading between $2 and $5, or well below the value of the company's distribution business without any consideration for NetRadio.
The information and statistical data contained herein have been obtained from sources which we believe to be reliable but in no way are warranted by us as to accuracy and completeness and does not purport to be a complete analysis of the securities, companies or industries involved. The information in this report is not intended to be used as the primary basis of investment decisions, and because of individual client objectives it should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions in this report are subject to change. This report is not and is under no circumstances to be construed as an offer to sell any securities. Delphi Financial Corporation's officers or stockholders may have a position in and may from time to time purchase or sell any of the securities mentioned in this report. Additionally, Delphi Financial Corporation has acted as a managing underwriter for the securities of Navarre Corporation in the past three years.
Navarre Corporation
Income Statement
Year Ends March
1995 1996 1997 1998 1999E 2000E
Computer Software $ 50,223 $ 105,575 $ 150,859 $ 137,479 $ 182,358 $ 234,000
Music $ 69,275 $ 52,779 $ 49,838 $ 59,169 $ 98,659 $ 125,500
Net Sales $ 119,498.0 $ 158,354.0 $ 200,697.0 $ 196,648.0 $ 281,017.0 $ 359,500.0
Cost of Sales $ 104,046.0 $ 138,503.0 $ 177,415.0 $ 171,655.0 $ 246,543.0 $ 312,385.0
% of Revenue 87.1% 87.5% 88.4% 87.3% 87.7% 86.9%
Gross Profit $ 15,452.0 $ 19,851.0 $ 23,282.0 $ 24,993.0 $ 34,474.0 $ 47,115.0
Gross Margin 12.9% 12.5% 11.6% 12.7% 12.3% 13.1%
Selling & Promotion 4,231.0 4,940.0 $ 5,669.0 $ 5,716.0 $ 7,444.0 $ 9,000.0
% of Revenue 3.5% 3.1% 2.8% 2.9% 2.6% 2.5%
Distribution & Warehousing 1,182.0 1,945.0 2,697.0 2,936.0 4,289.0 $ 5,000.0
% of Revenue 1.0% 1.2% 1.3% 1.5% 1.5% 1.4%
General & Administrative 6,066.0 8,234.0 $ 12,793.0 $ 13,535.0 $ 12,781.0 $ 17,200.0
% of Revenue 5.1% 5.2% 6.4% 6.9% 4.5% 4.8%
Amortization & Depr. of intangible assets 512.0 843.0 5,826.0 1,348.0 1,563.0 2,664.0
% of Revenue 0.4% 0.5% 2.9% 0.7% 0.6% 0.7%
Total Operating Expenses 11,991.0 15,962.0 26,985.0 23,535.0 26,077.0 33,864.0
% of Revenue 10.0% 10.1% 13.4% 12.0% 9.3% 9.4%
Operating Income (Loss) $ 3,461.0 $ 3,889.0 $ (3,703.0) $ 1,458.0 $ 8,397.0 $ 13,251.0
Operating Margin 2.9% 2.5% -1.8% 0.7% 3.0% 3.7%
Interest Expense (753.0) (1,521.0) $ (2,110.0) $ 3,108.0 $ 1,942.0 $ 2,000.0
Other Expense (40.0) (132.0) $ (184.0) $ 10.0 $ 210.0 $ 390.0
Pretax Income $ 2,668.0 $ 2,236.0 $ (5,997.0) $ (1,660.0) $ 6,245.0 $ 10,861.0
Pretax Margin 2.2% 1.4% -3.0% -0.8% 2.2% 3.0%
Income tax expense (benefit) 1,061.0 917.0 $ (527.0) $ (470.0) $ 2,499.0 $ 4,344.4
Tax Rate 39.8% 41.0% 8.8% 28.3% 40.0% 40.0%
Minority interest in subsidiary loss $ - $ - $ (719.0) $ 216.0 $ - $ -
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