Napster's New Gig

The original Napster made a name for itself as a haven for freeloaders. Can the new legal Napster (Nasdaq: NAPS) do the same?

Last night, the music subscription service posted fiscal second-quarter results that show modest top-line growth, less bottom-line bleeding, but perhaps more importantly, a surge in Web traffic after rolling out a free ad-supported service with limited streaming capabilities.

Let's dig into the numbers. Net revenue rose 9% to $25.5 million. The September quarter's deficit narrowed to $0.21 a share after posting a $0.32 per-share loss a year ago. Wall Street thought the company would bleed a little more and lose $0.27 a share for the period.

There was a red flag in the report. If you back out university subscriptions, the number of paid subscribers dipped over the last three months. That's not good. The company closed out June with 512,000 paying subscribers and wrapped up September with 518,000 listeners with open wallets. That may seem like marginal improvement, but the June figure included 4,000 college subscribers. That figure tends to fall off over the summer when school is out. In September, 31,000 of those 518,000 paying members were on university deals.

This is troublesome, but it's also worth noting that the company is making strides in packaging scaled-back offerings for free. Napster rolled out its free ad-supported music streaming service back in May, and it's definitely attracting a larger audience. This past quarter, traffic to Napster.com has spiked by 42% in terms of unique visitors over last year's showing. Last week, Napster also began offering free daily downloads. Yes, that kind of carrot has been used by companies like Apple (Nasdaq: AAPL) and Microsoft (Nasdaq: MSFT) before. It has just taken on a bit more urgency with Napster, even with a dedicated advertiser -- in this case Intel (Nasdaq: INTC) -- to see it through the first few months of the freebie downloads.

A cynic would argue that Napster blew it by embracing a free side model. Giving away the milk -- even if that milk is more like powdered milk, in the form of low sonic quality streams -- will make it harder to sell the cow. Could that be why its non-collegiate membership base is shrinking?

I don't think so. The competition is getting pretty heavy in this space. Napster and RealNetworks (Nasdaq: RNWK) used to own the music subscription space, but with the popularity of satellite radio and Internet music channels, there are too many distractions. Napster is playing it right. It's striking deals with cell phone companies and even with attention-swiping rival XM (Nasdaq: XMSR). Breaking new ground on the freebie front may not draw the most desirable crowd, but it's a crowd nonetheless. With companies like Google (Nasdaq: GOOG) starting to market audio ads, trust in Napster to find a way to monetize its survival.

Digital music is a high-growth industry that is often explored as part of the Rule Breakers newsletter service. XM is an active pick there. Microsoft and Intel are Inside Value newsletter service recommendations.

Longtime Fool contributor Rick Munarriz isn't a subscriber to any digital music service, even though he does have satellite radio. He does not own shares in any of the companies in this story. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy .