InfoSpaced Out

The Bellevue, Wash., company late Wednesday said one of its carrier partners, widely believed to be Cingular, the nation's largest wireless service provider, plans to develop direct licensing relationships with major record labels by next year. InfoSpace currently licenses songs from record labels, converts them into ringtones and sells them to wireless customers for use on cellphones. Cingular's move to deal directly with record labels "will negatively impact [InfoSpace's] revenues and operating results" by effectively eliminating the company's role as middleman.

Analysts predict the loss of this revenue stream could chop earnings by 20% and cut revenue by 30%. InfoSpace, which also has an online search unit as well as an online and mobile directory service, earned $1.60 a share in 2005 on revenue of $340 million. Wall Street was already looking for the bottom line to swing to the red this year, forecasting full-year losses of a penny a share, according to Thomson First Call.

In the first half of 2006, ringtones accounted for 48% of the company's revenue of $186 million. About $55 million of the $90 million in ringtone sales came from so-called label ringtones, fragments of actual songs licensed from record labels, then packaged and formatted by InfoSpace as downloadable files for cellphones. Cingular accounted for about 70% of that revenue, according to Mark May, an analyst at Needham & Co., a boutique New York investment bank. The Street's projections of 2006 full-year revenue average $383 million, according to First Call.

The loss of such a substantial portion of the business prompted analysts to slash 2007 earnings and revenue estimates. Scott Sutherland, of Los Angeles-based investment bank Wedbush Morgan, trimmed InfoSpace's projected 2007 earnings to 24 cents from 39 cents, a 39% cut for what was previously the high end of Wall Street estimates.

The company released a prepared statement saying it plans to "rationalize its costs to align them with expected future revenues." A company spokesman said specific plans will be detailed within 30 days.

The Analysis
More than a few voices from the Street said those plans really ought to feature contingencies to sell off other businesses and get money back to shareholders. InfoSpace got into the ringtone business in 2003, when it paid about $25 million for Moviso, but Cingular's decision chokes off the spigot for making money off snippets of songs like 50 Cent's "In Da Club" and "Since You've Been Gone" by Kelly Clarkson.

"Though unlikely, windup of business, sale of assets/remaining operations, and return of cash to investors are the most beneficial outcomes for investors at this point, in our view," wrote Sasa Zorovic of Oppenheimer & Co., an independent research firm in New York. "We believe that, given the rapidly evolving markets in which the company operates, the significantly impaired outlook for the markets it directly serves, the likely turmoil inside its employee ranks, its likely inability to recruit, motivate, and retain exceptional people needing to pull off a turnaround, we believe investors would be best served by a winding down/sale of remaining operations and return of cash to investors."

Jordan Rohan, of RBC Capital Markets, is no less blunt in his assessment of the company's post-ringtone future.

"People assume that InfoSpace will be unprofitable forever, but not if they hurry up and sell their company," he says. "It's time for a major transformation at InfoSpace."

Rohan says the $40 million average quarterly revenue from its online search unit alone will be attractive to a competitor like IAC/Interactive (IACI), which owns Ask.com, a rival search business. It could fetch as much as $250 million and "it would be almost immediately accretive" to an acquirer.

The Bottom Line
The Cingular announcement is only the first sour note in what promises to be a symphony of bad news for ringtone distributors.

"The Moviso acquisition was good while it lasted," Needham's May wrote Thursday, predicting sizable layoffs and adding that "we expect InfoSpace's other ringtone partners will go direct over the next year as well."

Even if the company wasn't getting squeezed by carriers making direct connections with music labels, technological changes by handset makers are shrinking the middleman's role, Rohan says.

"Essentially these guys distributed other people's content, and that's not a very good business," he says, but adds that getting song fragments into formats for downloading had once been a slow process. "The ringtone has to work with hundreds of handsets, and getting it ready to do that is an annoyance. It takes time, but the process has become less cumbersome, and that technology is starting to be built into phones."

Spiffy offerings from Motorola (MOT), which recently released the Q phone, and advances by Nokia (NOK) with music subscription services and the Chocolate phone, to name some examples, show how technology is bypassing that business model.

But Rohan also adds that ringtones are a bigger business outside the U.S. and offers a practical, personal rationale for why this might be the case.

"I keep my phone on vibrate," he says. "I don't want to hear it."