Stock Talk TMF Interview With President & CEO Nathan Schulhof

With Dave Marino-Nachison (TMF Braden)
December 13, 1999

Cupertino, Calif.-based (Nasdaq: AHWY) operates a website offering downloadable music and related content along with communication services, music retail, and other offerings. We spoke with President and CEO Nathan Schulhof about his vision of profitability and the potential of portable download player devices.

TMF: Could you start by describing and what the site's all about?

Schulhof: All right. First of all, is an entertainment and information destination. Our goal is that when people come for music, venues, entertainment, and audiobooks, will be the first place they will think of.

TMF: It's all downloadable?

Schulhof: Downloadable or streaming. We're not platform-dependent. If you come to, whatever you have on your system should work. Whether you have [Windows] MediaPlayer or RealNetworks, they will work. We also do MP3 for everything that we have. We rely on the standard that is acceptable to our users. We don't try to force anything for you to have to take something to listen to us.

TMF: How does that translate into revenue?

Schulhof: Well, that's a good question. We have this entertainment and information destination and we have integrated services, communication, and e-commerce. One of our unique features is that we have multiple streams of revenue. Many sites depend on advertising; many depend on e-commerce. We are the concert hall. People come to listen to audio and participate in our member services. In this we have advertising, typical banner ads like you see on other sites. We are the very first Internet site ever to do audio ads like the radio. Many of the sites actually copied our model.

"I don't believe the record stores will ever go away. They'll become better."
We also have direct commerce. About four or five months back we bought the assets of a company called MassMusic, which sells CDs on the Internet pretty much like CDNow (Nasdaq: CDNW). So now when you listen to any of this music you have the opportunity to purchase it, and MassMusic will send it out to you in just a few short days.

TMF: I've always been a big shopper for things like that online, and I know that certainly there have been tons of people to be more than happy to pay for those sort of things over the Internet. Do you think there will ever be a market for paying for a download?

Schulhof: I do. One of the reasons we purchased MassMusic besides revenue is to position ourselves for selling of the download. I've read all of the reports; there will be a market. How big is somewhat still unknown. We feel where this will go is music that's selling in the music stores will [also] be selling downloadable. We think that's some time away, and the music industry right now is allowing you to stream almost anything under certain guidelines, and eventually with certain protection and encryption we feel downloadable will be for sell.

Right now something that we do offer is a subscription for $39.95. Many times, business people like myself who come in in the morning -- one of my favorite things to do is read The Wall Street Journal. Many days I don't get to it, I hear about an article that I missed. You know that one news section that tells about what's in the Journal for today? For $39.95 you can get an e-mail that streams that to you every single day that lasts about five minutes approximately. We offer that on a subscription basis. You'll find other things where we start selling the download and that includes music.

TMF: The newspaper thing makes me think it's more event-based as opposed to "This is the new CD from Sting."

Schulhof: I think it will start there, but where I think it will end up is here's Sting's new album. You have theories, you have scare tactics, you have whole sides of the spectrum. One side is the record stores will go away. Quite frankly, I don't believe the record stores will ever go away. They'll become better.

It's very much like the personal computer's history. I don't know how old you are, but I've been in the industry since 1978 and when mail order first came about people could actually call up and get something mail order, have it arrive in a day or two, and the prices were about 20% to 30% less. There was a fear amongst the computer industry that the stores would go away. Well, they didn't. What grew were superstores.

Competition makes existing markets better. What I think will happen here is sometime in the future the latest and greatest music will be selling for downloadable on the Internet. You'll chose how do you want it, on a recordable CD, on a flash memory card, or whatever media is at the time. I don't think record stores will go away. I think they will become more competitive and offer more services that don't exist today.

I think it will start, where you pointed out, with events. If you recall, back in June of this year did something called Wango Tango where we had an exclusive on an eight-hour music event out of Dodger Stadium. We had Ricky Martin, who was on Time magazine that month. Britney Spears. We had UB40. We had Will Smith, who was promoting his movie. While you were hearing these artists, you had the opportunity to buy the songs. There were 57,000 people watching this eight-hour musical event called Wango Tango in Dodger Stadium, one of the biggest crowds Dodger Stadium ever had. If you weren't in Dodger Stadium, the only other place to watch and hear it was on, and for that weekend we had more than a half million people on.

TMF: Has that translated into more regular viewership to the site?

Schulhof: Yes. Our traffic has gone up. Our projections are more than 2 million visitors this month. Last December when we went public we had 176,000 visitors.

TMF: I've read a comment that you said a few months back that you expect to become profitable "before most Internet companies," I think the quote was. I looked over some of your recent financial statements and while you'd expect sales and marketing expenses to be rising pretty quickly, it also looks like operating and development costs and administrative costs have been rising more quickly than revenues. I wonder if you could break those down and talk about what it is that you're spending on.

Schulhof: One, let me be clear. I do expect us to be profitable before most Internet companies, but that will not be in the year 2000 or 2001. Most of our money is going into marketing and development. We've built out our members services area over the last couple months. This member services area features things like faxing, e-mail, and Web hosting. You'll see many other features. We're moving into areas -- I can't be specific because I can't give forward information -- but we're moving into areas of communications, everything from e-mail to community broadcast to many other features that you can't find on other sites.

The reason for this is we're giving our users a community effort. We're creating reasons why users come back more often and spend more time on our sites. By doing this we lower our acquisition cost per customer and it's easier to monetize.

TMF: So it sounds like where your profitability will probably come from in the nearer term will be from some of these costs going away as you finish establishing these services.

Schulhof: Our costs will level out. If you noticed, just revenue from second quarter to third quarter was up 146%. Without giving too much away here, you'll find the fourth quarter revenue jump substantially also. Maybe not 146%, but one that meets management's expectations.

TMF: Maybe now will be a good time to go back and talk about the handheld devices, some of these things like the Diamond Multimedia (Nasdaq: DIMD) Rio. People are talking about them, but they're not being carried around too much, and I wonder when you think they're going to take off?

Schulhof: I look at market projections. They are pretty popular. There's a research group out of Phoenix, Arizona, called Semico. It's a retail research group that projects there will be one million portable devices shipped this year. They also project that by 2002, there will be 15 million units per year. Now Forrester Research came out with a report that shows the projection that by the year 2003 there will be 30 million units per year being shipped.

TMF: When you say this, what are we talking about?

Schulhof: We're talking handheld portable devices that somewhat are comparable to a Diamond Rio or the Creative Labs [devices]. We've identified 30 companies -- including Sony (NYSE: SNE), Panasonic, Samsung as well as others -- that are shipping or have intentions to ship portable devices.

" views its patent as an asset and a valuable one, but that's our wild card."
Now, what I want to point out here is is not claiming that we own the Internet. It's not claiming that if you play downloadable music on a personal computer that you're in violation of our patent. We're not claiming that at all. What the investment community, and many manufacturers, need to realize is that we've been around since 1994. We were downloading audio on the Internet before anybody else. We built the first handheld player, called the ListenUp player. We built it. We shipped it. It's been written about in many magazines and we received awards for it.

Back then we were out touting our device and encouraging other people to join our partnership. Some of them were the main manufacturing firms that are now making one. So we built it and we shipped it. At the same time we sought patents on it. This is really what patent protection is all about. If you invent something and you build it and you invest millions of dollars, you have some ownership rights to it. So at this time the marketplace changed and companies see that this is going to be big and our visions came to fruition and does own this area and we have patent protection. If you would pull the patent and you look at the abstract drawing on the patent -- which was filed several years ago -- you would think you were looking at these handheld devices.

TMF: So is it an MP3 player that you're talking about?

Schulhof: The way our patent reads, it involves a handheld digital device that stores anything from hard drive to flash that comes from a computer to a high-speed network. It really doesn't matter whether it's an MP3 or some standard that hasn't been invented. We spent a lot of work on this and we invested a lot of money and we did pioneer and invent this space. But separate from the patent, we have four patents on file and we think that's a valuable asset of, but I don't like to play too much on patents until you receive licensing agreements or you win in court.

TMF: One thing I didn't know about going into this interview was the potential for license revenue. I guess you aren't collecting anything along those lines right now.

Schulhof: No, we're not, but we do have a plan and the plan is in process of being executed so I can't talk too much about it, but we can talk a bit about it. I'm asked a lot how much we receive on the patents and we're just starting discussions with potential licensees, so I can't really put a figure on there because it will hinder my negotiations or discussions. Typically in my research I find that typical royalties are anywhere from 2% to 5% of the retail price. So one can do the math and if you look at Forrester's projections of 30 million units per year in the year 2003, you get some rough idea.

What I do want to make very clear to readers of this interview is that views its patent as an asset and a valuable one, but that's our wild card and we think we're way undervalued as an audio entertainment site.

TMF: If you could give us some picture of your revenue breakdown by segment, that might be helpful I think.

Schulhof: Right now e-commerce is 60% to 70% of it. Advertising is 30% to 35%.

TMF: Is that the breakdown that you'd like, or I suppose you wouldn't mind having it be tilted more toward advertising?

Schulhof: I would. Higher margins are in advertising and our advertising has grown substantially. What we used to sell in a quarter of advertising we now sell in a month, and the good news is that we sell out our inventory every month and with traffic rising monthly it gives us more inventory to sell.

TMF: Is there a standard demographic for your users?

Schulhof: Because our diverse library -- with everything from audio books to classical music to hard rock or metal music -- it's one of the advantages that we can offer our advertisers. We're finding that 16- to 24-years-old is the [audience that the] Levi Strauss's and the Sony's and the advertisers want to reach. We find the people really spending money on the Web are 25 to 35 so we can focus on both those markets and divert the traffic to the proper area.

TMF: This might be a good time to wrap this up, but I wonder if there's anything that I may not have asked that you'd like to mention?

Schulhof: I'd like to really build your awareness of how, from an investment standpoint management, believes this company is way undervalued. If you want to talk about the comparisons, take a company like (Nasdaq: EMUS) that had 13-some million dollars in losses last quarter with revenues of roughly $4 million and look at their valuation. They bought (Nasdaq: TUNZ) for $140 million or something recently, and look at Audible (Nasdaq: ADBL) that was down 10%. You look at our revenue growth, our traffic growth. This is a company that is truly undervalued, and I think that in the year 2000 from some of the work, the expenditures that has made in 1999, this will become much more evident to Wall Street and we believe that you will find substantial growth, not only from traffic, revenue, but from awareness of the company on Wall Street.

TMF: I appreciate your taking the time.

Schulhof: Thank you.

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