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Napster's Download Duel

Q: When is it bad to see sales triple?

A: When net losses also triple.

Think that's impossible? Nay, Fool. That's exactly what Napster (Nasdaq: NAPS  ) did in the fourth quarter, according to yesterday's earnings report. Napster grew sales more than 180% to $17.1 million, up from $6.1 million in last year's fourth quarter. The music store's net loss, however, tripled from $0.20 per share to $0.60 per stub over the same period.

Not surprisingly, expenses also rose dramatically year over year. Cost of revenues, for example, rose 168%. Sales and marketing expenses were up a remarkable 374%. Overall, operating expenses nearly doubled. There's a reason for this, of course. With competition from Apple's (Nasdaq: AAPL  ) iTunes, RealNetworks' (Nasdaq: RNWK  ) Rhapsody, and now Yahoo! (Nasdaq: YHOO  ) , Napster has to spend -- big -- to win subscribers.

So far, the strategy has worked. Napster added 143,000 subscribers during the fourth quarter, partly the result of its Napster To Go service, which allows unlimited downloads of songs for playback in up to three MP3 players. It's a decent deal, economically. But only if you're into renting your music collection. Not enough mobile hipsters have signed on to the idea to make Napster a cash-positive business. Frankly, I wonder whether it ever will be.

Napster narrowed its loss for the full fiscal year but still bled nearly $30 million. The company argued in its earnings release that new services, such as Yahoo's, which offers unlimited downloading for $6.99 per month, will be operating at a loss, and that consumers ought to expect prices to rise over time. That's probably true. But does it matter? The more important question is this: At what point does it cost too much to acquire customers who can switch services with the click of a mouse?

Napster's business isn't like that of Sirius (Nasdaq: SIRI  ) or XM Satellite Radio (Nasdaq: XMSR  ) . There are only two alternatives in the satellite radio market, and there are some minor hassles that would come with switching, such as buying a new receiver. That's why both services have been willing to pay big to acquire content that lures consumers.

Impressive sales growth aside, Napster has a tough road ahead. But there is good news for investors crazy enough to take a flier on these shares: Napster has a strong cash position. Net cash and investments as of the latest quarter were $148.8 million, or $3.63 per share. That should set a floor for the share price, despite recent staggering declines, including today's near 6% drop. Just don't expect much upside soon.

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Fool contributor Tim Beyers likes his iTunes, but he also likes CDs, apple pie, and lemonade. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. You can find out what's in his portfolio by checking Tim's Fool profile, which is here. The Motley Fool has a disclosure policy.

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