Napster (NAPS) 10-Q 2008 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2008

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 000-32373

Napster, Inc.

(Exact name of Registrant as specified in its charter)

Delaware	77-0551214
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

9044 Melrose Avenue

Los Angeles, California 90069

(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code: (310) 281-5000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes   x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one):

Large accelerated filer  ¨	Accelerated filer  x
Non-accelerated filer  ¨	Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  ¨    No  x

As of August 8, 2008, there were approximately47,900,000shares of the registrant’s Common Stock outstanding, par value $0.001.

NAPSTER, INC.

TABLE OF CONTENTS

		Page Number
PART I.	Financial Information	1
Item 1	Financial Statements (unaudited)	1
	Condensed Consolidated Balance Sheets as of June 30, 2008 and March 31, 2008	1
	Condensed Consolidated Statements of Operations for the three months ended June 30, 2008 and 2007	2
	Condensed Consolidated Statement of Changes in Stockholders’ Equity for the three months ended June 30, 2008	3
	Condensed Consolidated Statements of Cash Flows for the three months ended June 30, 2008 and 2007	4
	Notes to Condensed Consolidated Financial Statements	5
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3	Quantitative and Qualitative Disclosures about Market Risk	21
Item 4	Controls and Procedures	22
PART II	Other Information	23
Item 1	Legal Proceedings	23
Item 1A	Risk Factors	23
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	33
Item 3	Defaults Upon Senior Securities	34
Item 4	Submission of Matters to a Vote of Security Holders	34
Item 5	Other Information	34
Item 6	Exhibits	34
Signatures		35
Index to Exhibits		36
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1

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Cautionary Note regarding Forward-Looking Statements

In addition to current and historical information, this Quarterly Report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to our future operations, prospects, potential products, services, developments and business strategies. These statements can, in some cases, be identified by the use of terms such as “may,” “will,” “should,” “could,” “would,” “intend,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “project,” “potential,” or “continue” or the negative of such terms or other comparable terminology. This Quarterly Report includes, among others, forward-looking statements regarding:

• growth in broadband Internet connectivity and consumer adoption of portable electronic devices driving growth in the online music industry and improving consumers’ access to digital media;

• our ability to successfully enter into additional strategic partnerships;

• our ability to control our subscriber cost and customer turnover;

• our ability to continue to innovate by investing in new services and technologies;

• our ability to build the Napster brand;

• our competitive advantages;

• our expectations regarding our future financial results, including with respect to revenues, gross margins, research and development expenditures, sales and marketing expense and general and administrative expenses;

• our expectations that our existing cash resources will be sufficient to fund our operations for at least the next twelve months; and

• our expectations that we will incur net losses for at least the next twelve months and may continue to experience net losses thereafter.

These statements involve certain known and unknown risks, and uncertainties that could cause our actual results to differ materially from those expressed or implied in our forward-looking statements. Such risks and uncertainties include, among others, those listed in Part II Item 1A, “Risk Factors” of this Quarterly Report on Form 10-Q. We do not intend, and undertake no obligation, to update any of our forward-looking statements after the date of this Quarterly Report to reflect actual results or future events or circumstances.

Napster, Napster Mobile, Napster To Go and Napster Light are either trademarks or registered trademarks of Napster, Inc. or its subsidiaries in the United States and/or other countries. All other trademarks are owned by their respective owners.

ii

PART I—FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

NAPSTER, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

(unaudited)

	As of
	June 30, 2008			March 31, 2008
ASSETS
Current assets:
Cash and cash equivalents	$	36,881		$	32,628
Short-term investments		30,731			37,164
Accounts receivable, net of allowance for doubtful accounts of $41 at June 30, 2008 and $16 at March 31, 2008		2,476			2,365
Prepaid expenses and other current assets		3,576			2,289
Total current assets		73,664			74,446
Long-term investments		2,708			—
Property and equipment, net		2,909			3,358
Goodwill		34,658			34,658
Identifiable intangible assets, net		3,011			3,560
Other assets		381			285
Total assets	$	117,331		$	116,307
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	2,950		$	1,745
Accrued liabilities		35,772			31,166
Deferred revenues		5,696			6,474
Total current liabilities		44,418			39,385
Long-term liabilities
Deferred income taxes		4,830			4,593
Other long-term liabilities		47			28
Total liabilities		49,295			44,006
Commitments and contingencies (Note 6)
Stockholders’ equity:
Common stock, $0.001 par value; Authorized: 100,000 shares; Issued and Outstanding: 47,853 shares at June 30, 2008 and 46,122 shares at March 31, 2008		48			46
Additional paid-in capital		266,931			266,447
Accumulated deficit		(199,028	)		(194,646	)
Accumulated other comprehensive income		85			454
Total stockholders’ equity		68,036			72,301
Total liabilities and stockholders' equity	$	117,331		$	116,307

The accompanying notes are an integral part of these condensed consolidated financial statements.

1

NAPSTER, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

	Three Months Ended June 30,
	2008			2007
Net revenues	$	30,317		$	32,254
Cost of revenues		22,012			23,451
Gross margin		8,305			8,803
Operating expenses:
Research and development		2,015			2,712
Sales and marketing		3,970			3,991
General and administrative		6,514			5,965
Amortization of intangible assets		550			1,539
Total operating expenses		13,049			14,207
Loss from operations		(4,744	)		(5,404	)
Other income, net		339			1,431
Loss before income tax benefit (provision)		(4,405	)		(3,973	)
Income tax benefit (provision)		23			(271	)
Net loss	$	(4,382	)	$	(4,244	)
Basic and diluted net loss per share	$	(0.10	)	$	(0.10	)
Weighted average shares used in computing net loss per share:
Basic and diluted		43,868			43,408

The accompanying notes are an integral part of these condensed consolidated financial statements.

2

NAPSTER, INC.

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN

STOCKHOLDERS’ EQUITY

(in thousands)

(unaudited)

	Common Stock			Additional Paid-in Capital			Accumulated Deficit			Accumulated Other Comprehensive Income			Total Stockholders’ Equity
	Shares Out-standing	Amount
Balance at March 31, 2008	46,122	$	46	$	266,447		$	(194,646	)	$	454		$	72,301
Net loss	—		—		—			(4,382	)		—			(4,382	)
Foreign currency translation adjustment	—		—		—			—			47			47
Unrealized loss on investments	—		—		—			—			(416	)		(416	)
Total comprehensive loss														(4,751	)
Issuance of common stock under employee stock plans, net of cancellations and share repurchases	1,731		2		(297	)		—			—			(295	)
Stock-based compensation expense	—		—		781			—			—			781
Balance at June 30, 2008	47,853	$	48	$	266,931		$	(199,028	)	$	85		$	68,036

The accompanying notes are an integral part of these condensed consolidated financial statements.

3

NAPSTER, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Three Months Ended June 30,
	2008			2007
Cash flows from operating activities:
Net loss	$	(4,382	)	$	(4,244	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		1,151			2,247
Amortization of prepaid marketing expenses		—			1,039
Stock-based compensation charges		781			1,117
Deferred tax expense		238			231
Change in operating assets and liabilities:
Accounts receivable		(110	)		(446	)
Prepaid expenses and other current and long term assets		(8	)		(34	)
Accounts payable		1,199			(527	)
Accrued liabilities		3,352			2,355
Deferred revenues		(777	)		(164	)
Other current and long-term liabilities		18			(1	)
Net cash provided by operating activities		1,462			1,573
Cash flows from investing activities:
Purchases of property, equipment and other assets		(277	)		(550	)
Purchases of short-term investments		(14,575	)		(19,411	)
Proceeds from maturities and sale of short-term investments		17,880			19,440
Net cash (used in) provided by investing activities		3,028			(521	)
Cash flows from financing activities:
Principal payment of capital lease obligation		—			(1	)
Repurchase of common stock under employee stock plans, net		(295	)		(504	)
Net cash used in financing activities		(295	)		(505	)
Effect of exchange rates on cash		58			48
Change in cash and cash equivalents		4,253			595
Cash and cash equivalents at beginning of period		32,628			30,069
Cash and cash equivalents at end of period	$	36,881		$	30,664

The accompanying notes are an integral part of these condensed consolidated financial statements.

4

NAPSTER, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 1—BASIS OF PRESENTATION

Basis of Presentation

The unaudited condensed consolidated financial statements have been prepared by Napster, Inc., a Delaware corporation (“Napster” or the “Company”), pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). The condensed consolidated balance sheet as of March 31, 2008, was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States. Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with generally accepted accounting principles in the United States have been condensed or omitted pursuant to such rules and regulations. However, Napster believes that the disclosures are adequate to make the information presented not misleading. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes included in Napster’s Annual Report on Form 10-K for the year ended March 31, 2008.

The condensed consolidated financial statements reflect all adjustments, which include only normal, recurring adjustments, that are, in the opinion of management, necessary to state fairly the results for the periods presented. The results for such periods are not necessarily indicative of the results to be expected for the full year.

The preparation of condensed consolidated financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

Our fiscal year end is March 31, and our fiscal quarters end on June 30, September 30 and December 31. Unless otherwise stated, all dates refer to our fiscal year and fiscal periods.

Advertising Costs

Advertising costs are expensed as incurred and were $1.9 million and $1.2 million for the three months ended June 30, 2008 and 2007, respectively

Fair Value Measurement

On April 1, 2008, the Company adopted the methods for determining fair value as described in SFAS No. 157, “Fair Value Measurements” (“SFAS 157”),to value its financial assets and liabilities. SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the principal or most advantageous market at the measurement date. SFAS 157 also establishes a fair value hierarchy that prioritizes observable and unobservable inputs used to measure fair value into three broad levels, which are described below:

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for assets or liabilities. The fair value hierarchy gives the highest priority to Level 1 inputs.

Level 2: Observable prices that are based on inputs not quoted on active markets, but corroborated by market data.

Level 3: Unobservable inputs are used when little or no market data is available. Level 3 inputs are given the lowest priority in the fair value hierarchy.

5

The adoption of SFAS 157 did not have a material impact on the Company’s consolidated financial statements.

NOTE 2—CASH, CASH EQUIVALENTS AND INVESTMENTS

Cash and Cash Equivalents (in thousands)

	Fair Value at
	June 30, 2008		March 31, 2008
Cash	$	11,886	$	11,512
Cash equivalents:
Commercial paper		7,146		5,243
Corporate securities		1,009		—
Money market funds		15,543		15,873
U.S. agencies securities		1,297		—
Total cash equivalents		24,995		21,116
Total cash and cash equivalents	$	36,881	$	32,628

Investments (in thousands)

	Fair Value at
	June 30, 2008		March 31, 2008
Short-term
Commercial paper	$	8,978	$	15,070
Asset backed securities		114		296
Corporate securities		14,660		14,775
Municipal securities		—		3,052
U.S. agencies securities		6,979		3,971
Total short-term	$	30,731	$	37,164
Long-term
Auction rate security	$	2,708	$	—
Total investments	$	33,439	$	37,164

Napster’s investments are all considered available for sale and, therefore, they are carried at estimated fair value.

Cash Equivalent and Investment Gains and Losses

Realized and unrealized gains and losses on investments are determined on the specific identification method. Realized gains and losses, amortization and accretion on cash equivalents and investments, net, totaled $174,000 and $385,000 for the three months ended June 30, 2008 and 2007, respectively. Gross realized losses on investments for the three months ended June 30, 2008 and 2007 were not significant.

Additionally, gross unrealized gains on cash equivalents and investments were $15,000 and $88,000 as of June 30, 2008 and March 31, 2008, respectively, and gross unrealized losses on cash equivalents and investments were $371,000 and $23,000 as of June 30, 2008 and March 31, 2008, respectively. Napster has determined that the gross unrealized losses on its available-for-sale securities as of June 30, 2008 are temporary in nature. At June 30, 2008, all but $1,000 of gross unrealized loss was less than 12 months old. At March 31, 2008, all of gross unrealized loss was less than 12 months old.

6

Fair Value

In accordance with the fair value hierarchy described in SFAS 157, all cash equivalents are considered level 1 as fair value is determined using quoted market prices. The fair value of Napster’s investments was determined as follows (in thousands):

	Fair Value Measurement at June 30, 2008
	Level 1		Level 2		Level 3		Total
Short-term
Commercial paper	$	8,978		—		—	$	8,978
Asset backed securities		114		—		—	$	114
Corporate securities		14,660		—		—	$	14,660
U.S. agencies securities		6,979		—		—	$	6,979
Total short-term	$	30,731		—		—	$	30,731
Long-term
Auction rate security	$	—	$	—	$	2,708	$	2,708
Total investments	$	30,731	$	—	$	2,708	$	33,439

At June 30, 2008, Napster held a $2.7 million investment in one AAA rated municipal auction rate security (“ARS”.) An ARS is a collateralized long-term debt instrument that provides liquidity through a Dutch auction process that resets the applicable interest rate at pre-determined intervals, typically every 7, 28 and 35 days. Napster has been unable to sell this security since April 2008 due to auction failure. As a result, the funds associated with these failed auctions will not be accessible until the issuer calls the security, a successful auction occurs, a buyer is found outside of the auction process, or the security matures. The underlying assets of the municipal auction rate securities Napster holds are generally student loans which are guaranteed by the U.S. government.

To date, the Company has collected all interest payable on the ARS when due and expects to continue to do so in the future. At this time, the Company has no reason to believe that the underlying issuer of this ARS is presently at risk or that the underlying credit quality of the assets backing this ARS has been impacted by the reduced liquidity of these investments.

Due to the lack of observable market quotes on the ARS, the Company derived fair value by utilizing a discounted cash flow model, where the expected cash flows of the ARS are discounted to the present using a yield that incorporates credit quality of the investment, compensation for illiquidity and future yield of the investment principal. This approach was validated by a market comparable method, where the auction rate securities are valued based on indications, from an unobservable secondary market, of what discounts buyers demand when purchasing similar ARSs.

Napster has the ability and intent to hold this ARS until a forecasted recovery of fair value up to the par value of the security, which in certain cases may mean final maturity of December 2017. The estimated fair value, derived from Level 3 under SFAS 157, for this ARS was below its par value at June 30, 2008. Napster recorded an unrealized loss of $300,000 due to the temporary decline in the value of this security. Due to the persistent failed auctions and the uncertainty of when the investment could be successfully liquidated at par value, the Company has recorded the ARS as a long-term investment at June 30, 2008.

7

The change in carrying value associated with the Level 3 financial asset for the three months ended June 30, 2008 was (in thousands):

	Securities Available for Sale, long-term
Balance at April 1, 2008	$	—
Transfer into Level 3		3,008
Total unrealized loss included in other comprehensive income		(300	)
Balance at June 30, 2008	$	2,708

NOTE 3— BALANCE SHEET DETAIL

Identifiable intangible assets, net (in thousands)

	June 30, 2008				March 31, 2008
	Gross Carrying Amount		Accumulated Amortization		Gross Carrying Amount		Accumulated Amortization
Identified intangible assets:
Patents	$	376	$	376	$	376	$	376
Trademarks		5,982		5,982		5,982		5,982
Customer intangible		8,000		4,989		8,000		4,440
Total	$	14,358	$	11,347	$	14,358	$	10,798
Net book value			$	3,011			$	3,560

Amortization of identifiable intangible assets was $549,000 and $1.5 million for the three months ended June 30, 2008 and 2007, respectively. The customer intangible is being amortized based on its estimated usage over a five-year period.

Accrued liabilities (in thousands)

	June 30, 2008		March 31, 2008
Accrued Liabilities:
Accrued affiliate and content liabilities	$	11,730	$	11,498
Accrued publishing fees		13,790		12,218
Accrued compensation and related expenses		1,811		1,365
Other accrued liabilities		8,441		6,085
Total accrued liabilities	$	35,772	$	31,166

8

NOTE 4—STOCKHOLDERS’ EQUITY

Stock Plans

The following table summarizes the activity relating to restricted stock awards (“RSAs”) and stock option grants for the three months ended June 30, 2008:

	Restricted Stock				Stock Options
	Unvested Shares		Weighted Average Grant Date Fair Value		Shares		Weighted Average Exercise Price
Outstanding at March 31, 2008	2,475,252		$	3.78	2,765,433		$	8.46
RSAs awarded/Options granted	1,983,500		$	1.40	173,000		$	1.40
RSAs vested	(585,780	)	$	4.13	N/A			—
Optons exercised	N/A			—	—			—
RSAs/Options forfeited	(50,417	)	$	3.98	(3,559	)	$	4.57
Options expired	N/A			—	(15,877	)	$	4.32
Outstanding at June 30, 2008	3,822,555		$	2.49	2,918,997		$	8.07
Outstanding at June 30, 2007	2,878,581		$	4.11

As of June 30, 2008, there was $6.3 million and $140,000 of total unrecognized compensation expense related to unvested restricted stock awards and stock options, respectively, which is expected to be recognized over the weighted-average periods of 3.24 and 2.84 years, respectively. The total fair value on the vesting date of restricted stock awards that vested during the three months ended June 30, 2008 and 2007 was $854,000 million and $1.5 million, respectively.

A total of 6.7 million common equivalent shares were excluded from the calculation of weighted average shares as of June 30, 2008 and 2007 because their effect would have been anti-dilutive.

NOTE 5—GEOGRAPHIC INFORMATION

Net Revenue

The following table presents net revenues from continuing operations by geographic location based on the entity that received the revenue (in thousands):

	Three Months Ended June 30,
	2008		2007
United States	$	23,423	$	26,958
Europe		6,894		5,296
	$	30,317	$	32,254

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Cash and Investments

The following table presents cash, cash equivalents and investments held in entities organized in the following legal jurisdictions (in thousands):

	June 30, 2008		March 31, 2008
United States	$	63,864	$	66,191
United Kingdom		1,019		989
Luxembourg		4,984		2,113
Germany		453		499
	$	70,320	$	69,792

Napster does not anticipate that it will incur any material U.S. income or foreign withholding taxes when cash is repatriated from the foreign entities to the United States.

NOTE 6—COMMITMENTS AND CONTINGENCIES

Litigation

Napster and Napster, LLC’s predecessor, Pressplay, have been notified by a number of companies that the Pressplay and Napster digital music services may infringe patents owned by those companies. Napster is investigating the nature of these claims and the extent to which royalties may be owed by Napster and Pressplay to these entities. The ultimate resolution of these claims cannot be determined at this time.

On October 8, 2004, SightSound Technologies, Inc. (“SightSound”) filed a lawsuit against Napster and Napster, LLC in U.S. District Court for the Western District of Pennsylvania (Case No. 2:04-cv-1549) alleging infringement of certain of its patents by the Napster service. SightSound is demanding monetary damages and injunctive relief. Napster was served with the complaint in the lawsuit on November 5, 2004. Napster answered the complaint and filed an application with the United States Patent and Trademark Office for reexamination of the patents. The court proceedings have been administratively closed pending the outcome of Napster’s reexamination application. In or around November 2005, SightSound sold the patents in question to a subsidiary of General Electric for an undisclosed amount. The Patent Office rejected all of the claims of each of the patents. In June 2007, General Electric filed an appeal of this decision with the Patent Office.

On August 5, 2005, Ho Keung Tse filed suit against Apple Computer, Inc., Napster, MusicMatch, Inc., Sony Connect, Inc., Yahoo, Inc. and RealNetworks, Inc. in U.S. District Court for the District of Maryland (Case No. 1:05-cv-2149) alleging infringement of U.S. Patent No. 6665797 by the defendants’ respective music distribution services. Mr. Tse is demanding monetary damages and injunctive relief. The defendants have formed a joint defense group and intend to defend themselves vigorously. The defendants were granted change of venue to the District of Northern California (Case No. 4:06- cv-06573-SBA), where, on October 4, 2007, the court stayed the litigation pending the reexamination of the related patent by the United States Patent and Trademark Office.

10

On December 15, 2005, MCS Music America, on behalf of itself and other publishers filed suit against Napster in U.S. District Court for the Middle District of Tennessee alleging that Napster had unlawfully distributed copyrighted musical compositions owned by the plaintiffs (Case No. 3:05-cv-1053). In November 2006, the plaintiffs sought and were granted a voluntary dismissal without prejudice. On November 15, 2006, Napster filed a complaint for declaratory relief against the former plaintiffs in Case No. 3:05-cv-1053 in the U.S. District Court for the Central District of California (Case No. 2:06-cv-7285). On December 15, 2006, the same plaintiffs re-filed their suit against Napster in U.S. District Court for the Middle District of Tennessee (Case No. 3:06-cv-01197). On March 7, 2007, the judge in the Tennessee case granted Napster’s motion to transfer Case No. 3:06-cv-01197 to the Central District of California as well. MCS demanded monetary damages and injunctive relief. A portion of this matter was settled for a nominal amount in April 2008. In July 2008, the remainder of the case was dismissed, resulting from the parties entering into a confidential settlement agreement whereby MCS Music America and the related publishers released all claims against the Company in exchange for a payment by the Company, which will be funded entirely by the Company's insurance carrier(s).

On November 20, 2006, Antor Media Corporation filed suit against Napster and others in U.S. District Court for the Eastern District of Texas (Case No. 5:06-cv-270) alleging infringement of U.S. Patent No. 5734961 by the defendants’ respective products and services. Antor is demanding monetary damages and injunctive relief. The defendants have formed a joint defense group and intend to defend themselves vigorously. On December 14, 2007, the United States Patent and Trademark Office issued an office action rejecting all of the claims relating to such patent and limiting Antor’s time to appeal such rejection. Antor filed a response to the office action on February 14, 2008, and the parties await further action.

On December 29, 2006, Intertainer, Inc. filed suit against Napster and others in U.S. District Court for the Eastern District of Texas (Case No. 2:06-cv-549) alleging infringement of U.S. Patent No. 6925469 by the defendants’ respective products and services. Intertainer is demanding monetary damages and injunctive relief. Napster has joined a joint defense group, and the parties intend to defend themselves vigorously. On February 13, 2008, the United States Patent and Trademark Office issued an order rejecting all of the claims on the patent. On March 12, 2008, the court stayed the litigation pending the reexamination of the patent by the Patent Office.

On September 11, 2007, Premier International Associates filed suit against Napster and others in U.S. District Court for the Eastern District of Texas (Case no. 2: 07-cv-396) alleging infringement of U.S. Patent Nos. 6,243,725 and 6,763,345 by the defendants’ products and services. Premier is demanding monetary damages and injunctive relief. Napster has joined a joint defense group, and the parties intend to defend themselves vigorously. The United States Patent and Trademark Office is currently re-examining the related patents, and the court has ordered a stay in the litigation pending the outcome of the re-exam.

On November 16, 2007, MOEAC, Inc. filed suit against Napster and others in U.S. District Court for the Western District of Wisconsin (Case no. 07-c-0654-S) alleging infringement of U.S. Patent nos. 6,232,539 and 7,205,471 by certain of Napster’s products and services. MOAEC is demanding monetary damages and injunctive relief. Napster is reviewing the claims and intends to defend itself vigorously.

For each of the above matters, except as specifically indicated above, management believes that it is not currently possible to estimate the impact, if any, that the ultimate resolution of these matters will have on Napster’s business, results of operations, financial position or cash flows.

Napster is a party to other litigation matters and claims from time to time in the ordinary course of its operations, including copyright infringement litigation for which it is entitled to indemnification by content providers. While the results of such litigation and claims cannot be predicted with certainty, Napster believes that the final outcome of such matters will not have a material adverse impact on its business, financial position, cash flows or results of operations. In July 2008, Napster settled one such claim for a nominal amount, which was accrued at June 30, 2008.

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Indemnification

In December 2004, as part of the sale of substantially all of the assets and liabilities of CSD to Sonic, Napster agreed to indemnify Sonic for unpaid tax liabilities with respect to any tax year ended on or before December 17, 2004 (or for any other tax year to the extent allocable to the portion of such period beginning before and ending on December 17, 2004), to the extent such tax liabilities neither are reflected in the closing working capital calculation pursuant to the sale agreement nor create a realized reduction in Sonic’s tax liabilities. Napster also agreed to indemnify Sonic for damages that relate to certain other tax-related matters, as described in the sale agreement. No limitation is set forth on the period of time by which a claim must be made pursuant to the foregoing indemnities nor is there a specified limitation on the maximum amount of potential future payments.

Obligations to content and distribution providers

Napster has certain royalty commitments associated with the licensing of the music content. Future payments under these content publishing agreements are due to partners based upon net revenues and online music distribution volumes.

NOTE 7—RECENT ACCOUNTING PRONOUNCEMENTS

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations”, which replaces SFAS No. 141, Business Combination. SFAS No. 141(R) retains the underlying concepts of SFAS No. 141 in that all business combinations are still required to be accounted for at fair value under the acquisition method of accounting, but SFAS No. 141(R) changed the method of applying the acquisition method in a number of significant aspects. SFAS No. 141(R) is effective on a prospective basis for the Company beginning April 1, 2009, with the exception of the accounting for valuation allowances on deferred taxes and acquired tax contingencies under SFAS No. 109, which were effective on the date of issuance of this statement. Early adoption is not allowed. Adoption of this statement is not expected to have a material impact on the Company’s consolidated financial position or results of operations.

In February 2008, the FASB issued FASB Staff Position No. 157-2, which delays the effective date of SFAS 157 for one year for all nonfinancial assets and liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company does not have nonfinancial assets and nonfinancial liabilities that are required to be measured at fair value on a recurring basis. Based on this guidance, the Company expects to adopt the provisions of SFAS 157 as related to nonfinancial assets and nonfinancial liabilities, effective April 1, 2009. Adoption of this statement is not expected to have a material impact on the Company’s consolidated financial position or results of operations.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the financial statements and notes thereto included elsewhere in this Quarterly Report. The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from the results contemplated by these forward-looking statements due to certain factors, including those discussed in Part II Item 1A “Risk Factors” and elsewhere in this Quarterly Report.

Management’s Discussion and Analysis of Financial Condition and Results of Operations is organized as follows:

• Executive Summary—a high level discussion of the business including a discussion of our strategy, opportunities, challenges and risks.

• Critical Accounting Policies and Estimates—a discussion of accounting policies that require critical judgments and estimates.

• Results of Operations—an analysis of our consolidated results of operations for the periods presented in our financial statements.

• Liquidity and Capital Resources—an analysis of cash flows, sources and uses of cash, and contractual obligations.

• Recent Accounting Pronouncements—information on recent accounting pronouncements.

Executive Summary

Napster, a pioneer in digital music, offers interactive music services that enable fans to sample, listen to, subscribe to and purchase from one of the world’s largest and most diverse online music catalogs utilizing secure and legal platforms anytime, anywhere. Napster users have access to songs from all major labels and thousands of independent labels, and have many ways to discover, share, acquire and enjoy new music and old favorites.

Subscribers to the Napster service receive unlimited access to our more than 6 million song catalog. Subscribers can either stream or download music with high quality sound and enjoy their music in an advertising-free environment. In addition, subscribers can access many features including radio, Billboard charts and community features, and are able to enjoy their music on a variety of media including personal computers, CDs, MP3 players, music-enabled cellular phones, PDAs and digital media devices for the living room.

All Napster users, whether subscribers or not, may listen to free music clips and may purchase full length music downloads. We offer downloads in the user-friendly, DRM-free, MP3 format, which is compatible with virtually any MP3 player or music phone, including the iPod and iPhone, in the United States. Outside the United States, we currently offer DRM downloads only.

Napster Mobile, our service available over certain carrier wireless networks, gives members access to our extensive song catalog via over-the-air downloads, ringtones, wallpapers as well as other personalization products.

Napster services are currently available in the Americas, Europe and Japan.

Our overall strategy is to attain profitability by continuing to pursue and execute strategic partnerships, continuing to innovate by investing in new services and technologies, and continuing to control our subscriber customer acquisition cost and customer turnover.

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We derive our primary revenues from online subscriptions and permanent music downloads. The paid Napster service offers subscribers on-demand web access to a wide variety of music that can be streamed or downloaded as well as the ability to purchase individual tracks or albums on an a la carte basis. Subscription and permanent download fees are paid by end user customers in advance via credit card, online payment systems or redemption of pre-paid cards, gift certificates or promotional codes. Napster’s Mobile service, offering over-the-air downloads, is paid by each applicable partner based on actual usage. Napster also periodically licenses merchandising rights and resells hardware that our end users may utilize to store and play their digital music content.

The market for digital music is growing rapidly. We expect our digital music distribution business to continue to grow as the industry expands and, in particular, once new compatible devices become available. The digital music market is highly competitive and we expect competition to continue to increase in the future as the market expands. We believe that the principal competitive factors affecting the market for our services include compatibility with popular hardware devices, song quality, search capability, personalization, programming, price and performance, other features, quality of customer support and brand. We believe that we compete more favorably than many of our current competitors with respect to some or all of these factors.

From the acquisition of Pressplay on May 19, 2003 through the end of fiscal 2007, our digital music distribution business operated at a loss and with negative cash flow. Since fiscal 2008 we operated at a loss, but achieved positive cash flow. We expect to continue to operate at a loss near term due to our significant investments to enhance service capabilities, market our products and grow worldwide. We expect our existing cash resources to be sufficient to fund our operations for at least the next twelve months.

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from our estimates.

An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used or changes in the accounting estimate that are reasonably likely to occur could materially change the financial statements. There have been no significant changes during the three months ended June 30, 2008 to the items that we disclosed as our critical accounting policies and estimates in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended March 31, 2008.

Results of Operations

Our fiscal year ends on March 31, and our fiscal quarters end on June 30, September 30 and December 31. Unless otherwise stated, all dates refer to our fiscal year and fiscal periods.

The financial information presented in this Quarterly Report is not necessarily indicative of our financial position, results of operations or cash flows in the future.

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Net Revenues

The following table sets forth, for the periods indicated, the summary of our revenues by geography (in thousands, except percentages):

	Three Months Ended June 30,				As a Percentage of Net Revenues Three Months Ended June 30,
	2008		2007		2008		2007
Revenues:
North America	$	23,423	$	26,958	77	%	84	%
Europe		6,894		5,296	23	%	16	%
Net revenues	$	30,317	$	32,254	100	%	100	%

Net revenues are comprised of the amounts we directly charged end users, net of refunds, our net proceeds from third parties that resell our services and for which we are required to report revenue “net” in accordance with EITF 99-19, royalties received on service revenues earned through our joint venture partnership, and other amounts received from third parties for the right to promote or distribute our services, net of any consideration paid to those customers in accordance with EITF 01-09.

Net revenues decreased $1.9 million for the first quarter of fiscal 2009 compared to the first quarter of fiscal 2008 primarily due to a $2.2 million decrease in revenues attributable to our subscribers offset by approximately $300,000 increase in revenues attributable to non-subscribers. Revenue from subscribers decreased primarily because our paid subscriber count decreased year over year.

Paid subscribers at June 30, 2008 were approximately 708,000 compared to 761,000 at March 31, 2008. This decrease occurred because new added subscribers were not sufficient to offset our normal cancellations during the period.

North America revenue decreased for the first quarter of fiscal 2009 compared to the first quarter of fiscal 2008 primarily due to decline in subscriber revenue. European revenue increased for the first quarter of fiscal 2009 compared to the first quarter of fiscal 2008 primarily because our European subscribers increased year over year.

Net revenues in our second fiscal quarter will be impacted by summer seasonality. Our revenue levels will depend upon the pace of our Napster Mobile roll outs, including new compatible handsets and other carrier promotions, as well as other new marketing initiatives. We expect revenue growth to resume in the second half of the year as we hit the Christmas season and due to anticipated further expansion of Napster Mobile. Finally, we anticipate that the proportion of revenue outside of the United States will fluctuate as a result of continued marketing activities and initiatives focused on world-wide customer growth.

Gross Margin

The following table sets forth, for the periods indicated, our gross margins (in thousands, except percentages):

	Three Months Ended June 30,				As a Percentage of Net Revenues Three Months Ended June 30,
	2008		2007		2008		2007
Gross Margin	$	8,305	$	8,803	27	%	27	%

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Gross margin is the profit from revenues after deducting the cost of royalties to content providers and publishers, technical support, bandwidth, hosting, order fulfillment services, shipping, product costs, depreciation and amortization of infrastructure related to the delivery of the services, and any other direct costs of providing the services, product, or trademark licenses.

Gross margin as a percentage of related revenue remained flat for the first quarter of fiscal 2009 compared to the first quarter of fiscal 2008.

Service headcount dedicated to maintaining content and providing customer care was 12 and 13 at June 30, 2008 and 2007, respectively.

Near term, we expect gross margins to fluctuate to the extent that our direct costs fluctuate and depending on our product mix.

Operating Expenses

We classify operating expenses as research and development, sales and marketing and general and administrative. Each category includes related expenses for salaries, employee benefits, incentive compensation, stock-based compensation, travel, telephone, communications, facility costs and professional fees. Our sales and marketing expenses include additional expenditures specific to the marketing group, such as public relations, advertising, trade shows, marketing collateral materials and subscriber acquisition costs, as well as expenditures specific to the sales group, such as commissions and referral fees paid to marketing partners. In addition, we include certain amortization of identifiable intangible assets as operating expenses.

The following table sets forth, for the periods indicated, our operating expenses (in thousands, except percentages):

	Three Months Ended June 30,				As a Percentage of Net Revenues Three Months Ended June 30,
	2008		2007		2008		2007
Research and development	$	2,015	$	2,712	7	%	8	%
Sales and marketing		3,970		3,991	13	%	12	%
General and administrative		6,514		5,965	21	%	18	%
Amortization of intangible assets		550		1,539	2	%	5	%
	$	13,049	$	14,207	43	%	43	%

Research and Development

Research and development (“R&D”) expenses consist primarily of salary, benefits (including stock-based compensation) and contractors’ fees for our development and other costs associated with the minor enhancements of existing products, development of new services or development of new features for existing services.

R&D expenses decreased for the first quarter of fiscal 2009 as compared to the first quarter of fiscal 2008, primarily due to lower stock-based compensation expense and lower personnel costs.

Research and development headcount was 60 and 62 at June 30, 2008 and 2007, respectively.

We expect future research and development expenses to fluctuate depending on our level of investment in new product enhancements and on whether those development projects qualify for capitalization in accordance with generally accepted accounting principles.

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Sales and Marketing

Sales and marketing expenses consist primarily of salary and benefits (including stock-based compensation) for sales and marketing personnel, referral fees paid to marketing partners, other subscriber acquisition costs, as well as costs associated with advertising and promotions.

Sales and marketing expenses remained flat for the first quarter of fiscal 2009 compared to the first quarter of fiscal 2008 because changes in our personnel costs were offset by comparable changes in our marketing program spend.

Sales and marketing headcount was 27 and 29 at June 30, 2008 and 2007, respectively.

We expect sales and marketing expenses to fluctuate in the future as our subscriber growth fluctuates, because our most significant sales and marketing cost is incurred as we add new subscribers through our strategic partnerships.

General and Administrative

General and administrative expenses consist primarily of salary and benefits (including stock-based compensation) for executive and administrative personnel, professional services, administrative outsources and other general corporate activities.

General and administrative expenses increased for the first quarter of fiscal 2009 compared to the first quarter of fiscal 2008 primarily due to an $800,000 increase in legal fees in connection with our defense of certain asserted legal claims, some of which were settled during July 2008.

General and administrative headcount, including all corporate general and administrative employees, was 41 at June 30, 2008 compared to 38 at June 30, 2007.

Excluding legal fees, which fluctuate based on when we have to address legal matters and asserted claims, we expect general and administrative expenses to remain relatively flat as we continue to focus on controlled spending.

Amortization of Intangible Assets

We have amortization expense associated with acquired customer intangible assets. Future amortization expense will reflect the pattern in which the economic benefits of that customer intangible asset are consumed.

Other Income, Net

Other income, net, consists primarily of interest income on our cash equivalents and investments, realized gains (losses) on investments, interest expense and other miscellaneous income.

Other income, net, decreased approximately $1.1 million in the first quarter of fiscal 2009 compared to the first quarter of fiscal 2008 due primarily to lower interest income based on lower interest yields, higher foreign currency remeasurement losses and a $638,000 benefit recognized upon the resolution of contingencies related to the Roxio spin off from Adaptec in the first quarter of fiscal 2008.

We expect other income, net, to vary in the future due to investment rate changes, foreign currency fluctuations and other non-recurring items.

Income Tax Provision

We have recorded a valuation allowance to reduce deferred tax assets to the amount we believe is more likely than not to be realized. In the event that deferred tax assets would be realizable in the future in excess of the net recorded amount, an adjustment to the valuation allowance on deferred tax assets would increase income in the period such determination was made.

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During January 2005, following the divestiture of CSD, which utilized substantially all of our tax operating losses, Napster made a tax election to step up the basis in Pressplay goodwill for tax purposes. As a result, the Pressplay goodwill is deductible for tax purposes, which creates a tax timing difference that is presented as a deferred tax liability and deferred tax expense. As realization of this taxable temporary difference is not assured, a net tax expense related to this item is recorded.

The net income tax benefit for the first quarter of fiscal 2009 represents the quarterly tax provision offset by approximately $300,000 tax benefit upon closure of an income tax audit related to a formerly owned foreign subsidiary. The quarterly tax provisions in both years represent primarily state franchise taxes, foreign taxes and the timing difference related to the Pressplay goodwill. We are subject to various tax rates in the jurisdictions in which we do business. Our tax provision does not take into account any future benefit from loss carryforwards, which may be realized if we again achieve profitability and begin generating taxable income.

In the near term, we expect to continue to incur operating losses from operations, and therefore to have minimal tax provisions other than the timing difference related to the Pressplay goodwill.

Liquidity and Capital Resources

At June 30, 2008, Napster had $70.3 million in cash, cash equivalents and investments. These amounts consist principally of commercial paper, corporate securities, U.S. agencies securities, asset backed securities, an auction rate security and money market funds. This balance represents a $528,000 increase as compared to cash, cash equivalent and investments at March 31, 2008.

Our primary ongoing source of cash is receipts from revenues. The primary uses of cash are payroll (salaries and related benefits), general operating expenses (marketing, travel and office rent), payments to content providers, payments for products held for resale, and purchases of property and equipment, including software development costs.

We have significant non-cash expenditures, such as depreciation and amortization, amortization of prepaid marketing expenses, stock based compensation charges and deferred tax expense. We also have significant non-cash changes in working capital, such as accruals for music publishing fees, for which rates have not been finalized and thus only partial payments are being made. When music publishing fee rates are established, we will be obliged to make retroactive payments for certain unpaid music publishing fees since the inception of Pressplay. As of June 30, 2008, we have accrued $12.8 million for these fees, which once finalized, are likely to be payable during calendar 2009.

The municipal securities we held at June 30, 2008 were comprised of one $2.7 million, AAA rated, auction rate security (“ARS”) with underlying assets of student loans guaranteed by the U.S. government. We have been unable to sell this security since April 2008 due to auction failure. As a result, the funds associated with these failed auctions will not be accessible until the issuer calls the security, a successful auction occurs, a buyer is found outside of the auction process, or the security matures. Because it may take in excess of twelve months for the market of student loan ARS’ to recover, we have moved this ARS to long-term investments from short-term investments at June 30, 2008.

We have the ability and intent to hold this ARS until a forecasted recovery of fair value up to the par value of the security, which in certain cases may mean final maturity. To date, we have collected all interest payable on this investment when due and expect to continue to do so in the future. While the recent auction failure may limit our ability to liquidate this investment for some period of time, we do not believe the auction failures will materially impact our ability to fund our working capital needs, capital expenditures, or other business requirements in the next twelve months.

Our working capital was $29.2 million at June 30, 2008 compared to $35.1 million at March 31, 2008. The change in our working capital includes the reclassification of the $2.7 million ARS from short-term investment to long-term investments at June 30, 2008.

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Financial Position

We believe that the liquidity provided by existing cash, cash equivalents and investments will provide sufficient capital to meet our requirements for at least the next 12 months. Napster operates and will continue to operate in the near term at a loss.

We do not currently hold any debt. Accordingly, we have not been exposed to near-term adverse changes in interest rates or other market prices. We may, however, experience such adverse changes if we incur debt or hold other derivative financial instruments in the future.

Cash Flows

The following table sets forth, for the periods indicated, the components of cash flow activities (in thousands):

	For the three months ended June 30,
	2008			2007
Net loss	$	(4,382	)	$	(4,244	)
Non-cash expenses		2,170			4,634
Changes in operating assets and liabilities:		3,674			1,183
Net cash provided by operating activities	$	1,462		$	1,573
Net cash (used in) provided by investing activities	$	3,028		$	(521	)
Net cash used in financing activities	$	(295	)	$	(505	)

Cash provided by (used in) operating activities is driven by our net loss, adjusted for non-cash items, and change in operating assets and liabilities. Non-cash adjustments include depreciation and amortization, amortization of prepaid marketing expenses, stock-based compensation expense and deferred income taxes. Other cash changes in operating assets and liabilities include the deferral of revenue, vendor prepayments, and ongoing payment, accrued liabilities and collection of trade payables and receivables.

Cash provided by (used in) investing activities is primarily attributable to purchases and sales of investments and capital expenditures.

Cash provided by (used in) financing activities is driven by our financing activities relating to employee stock plans and principal payments of capital lease obligations.

The $110,000 decrease in net cash provided by operating activities in the first quarter of fiscal 2009 compared to the first quarter of fiscal 2008 is due to (1) the $138,000 higher net loss in the first quarter of fiscal 2009, (2) the $2.4 million of lower non-cash expenses in the first quarter of fiscal 2009, related primarily to amortization of assets recorded as part of the AOL customer acquisition in fiscal 2007 and lower stock-based compensation expense, offset by(3) $1.1 million of increased accruals for legal fees in the first quarter of fiscal 2009, and (4) an approximately $1.3 million net increase in other changes in working capital items.

The decrease in net cash provided by investing activities in the first quarter of fiscal 2009 compared to the first quarter of fiscal 2008 is primarily due to the fact that, after funding the $277,000 of capital expenditures and other assets in the first quarter of fiscal 2009, we moved available funds from short-term investments to cash-equivalent investments because they provide more stability amid the current market turmoil. In the first quarter of fiscal 2008, we used $550,000 in capital expenditures.

Financing activities in both fiscal 2009 and 2008 were due to required minimum tax withholding on employee stock plan activity.

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Off-Balance Sheet Arrangements

As of June 30, 2008, we did not have any off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

Recent Accounting Pronouncements

For recent accounting pronouncements, see Note 7 – Recent Accounting Pronouncements to the condensed consolidated financial statements appearing in Item 1, Part I to this Quarterly Report, which are incorporated by reference into this Item 2, Part I.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk

The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. We maintain our cash, cash equivalents and investments with high quality financial institutions and, as part of our cash management process, we perform periodic evaluations of the relative credit standing of these financial institutions. Amounts deposited with these institutions may exceed federal depository insurance limits. In addition, the portfolio of investments conforms to our policy regarding concentration of investments, maximum maturity and quality of investment.

Some of the securities in which we have invested may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline in value. To reduce this risk, we maintain our portfolio of cash equivalents and investments in a variety of securities, including commercial paper, corporate securities, U.S. agencies securities, asset-backed securities and money market funds. In general, money market funds are not subject to interest rate risk because the interest paid on these funds fluctuates with the prevailing interest rate.

At June 30, 2008, all $30.7 million of our short-term investments are subject to market risk and mature within one year. The weighted-average yield of those short-term investments was 3.76% at June 30, 2008. The weighted-average yield of the $2.7 million long-term investment was 3.24% at June 30, 2008. Our cash equivalents are invested in commercial paper, corporate securities, U.S. agencies securities and money market funds, which are not considered “subject to market risk” because those funds are not subject to significant interest rate risk due to their short maturities.

We do not currently hold any variable interest rate debt. Accordingly, we have not been exposed to near-term adverse changes in interest rates or other market prices. We may, however, experience such adverse changes if we incur debt or hold other derivative financial instruments in the future.

Financial instruments that potentially subject us to significant concentrations of credit risk consist principally of trade accounts receivable and accounts payable.

Market Risk

At June 30, 2008, we held a $2.7 million investment in one AAA rated auction rate municipal security, for which the underlying assets are student loans guaranteed by the U.S. government. We have been unable to sell this security since April 2008 due to auction failure. As a result, the funds associated with these failed auctions will not be accessible until the issuer calls the security, a successful auction occurs, a buyer is found outside of the auction process, or the security matures. See Liquidity and Capital Resources appearing in Item 2 of this Report.

Exchange Rate Risk

We market our Napster service in North America, Japan and Europe, resulting in transactions denominated in U.S. dollars, Canadian dollars, United Kingdom pounds, Euro, Swiss Francs and Japanese yen. As such, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets.

Transactions denominated in currencies other than the functional currency of the legal entity are remeasured to the functional currency of the legal entity at the period-end exchange rates. Any associated currency re-measurement gains and losses are recognized in current operations.

For our foreign subsidiaries whose functional currency is the local currency, we translate assets and liabilities to U.S. dollars using period-end exchange rates and translate revenues and expenses using average exchange rates during the period. Exchange gains and losses arising from translation of foreign entity financial statements are included as a component of other comprehensive income (loss).

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Cash and cash equivalents are predominantly denominated in U.S. dollars. As of June 30, 2008 we held the equivalent of U.S. $5.2 million of cash and cash equivalents in United Kingdom pounds, U.S. $3.8 million in Euro and approximately U.S. $672,000 in other foreign currencies.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Our management has evaluated, with the participation of our Chief Executive Officer and our interim Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our interim Chief Financial Officer have concluded that our disclosure controls and procedures were effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that our disclosure controls and procedures were also effective to ensure that information required to be disclosed in such reports is accumulated and communicated to our management, including our Chief Executive Officer and our interim Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure.

Changes in Internal Control Over Financial Reporting

During the quarter ended June 30, 2008, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II—OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

For legal proceedings, see Note 6 – Commitments And Contingencies to the condensed consolidated financial statements appearing in Item 1, Part I to this Quarterly Report, which is incorporated by reference into this Item 1, Part II.

ITEM 1A. RISK FACTORS

We have updated the risk factors discussed in Item 1A of our Annual Report on Form 10-K for the year ended March 31, 2008. We do not believe any of the updates constitute material changes from the risk factors previously disclosed in that report. For convenience, our risk factors, as updated, are included below in this Item 1A.

In addition, investing in our common stock involves a high degree of risk. You should carefully consider the risks described below and the other information in this Quarterly Report. If any of the following risks occur, our business could be materially harmed, and our financial condition and results of operations could be materially and adversely affected. As a result, the price of our common stock could decline, and you could lose all or part of your investment.

Our digital music distribution business has a limited operating history and a history of losses and may not be successful.

On May 19, 2003, we acquired substantially all of the ownership interests of Napster, LLC (f/k/a Pressplay). We used the Pressplay-branded service as a technology platform to roll-out our online music services division in October 2003. The business models, technologies and market for digital music services are developing. Prior to our acquisition of Napster, LLC, consumer adoption and usage of the Pressplay-branded service had not been significant. You should consider our business and prospects in light of the risks, expenses and difficulties encountered by companies in their early stage of development.

Our digital music distribution business has experienced significant net losses since its inception and, given the significant operating expenditures associated with our business plan, we expect to incur net losses for at least the next twelve months and will likely continue to experience net losses thereafter. No assurance can be made that our Napster services will ever contribute net income to our statement of operations. During the period beginning April 1, 2003, just prior to our acquisition of Pressplay in May 2003, through June 30, 2008, we incurred approximately $213.2 million of after tax losses from our digital music distribution business.

The success of our paid Napster service depends upon our ability to add new subscribers and retain existing subscribers.

We cannot assure you that we will be able to attract new subscribers or that existing subscribers will continue to subscribe. Trial subscribers and users of our free music service may choose not to become paid subscribers, and paid subscribers may decide to cancel their subscriptions, for many reasons including a perception that they do not use the services enough to justify the expense or that the service does not provide enough value or availability of content relative to our competition. In addition, any reduction in our current level of marketing and advertising expenditures may result in a reduction in the number of new trial and paid subscribers.

The early stages of subscription services such as ours are characterized by higher than normal churn rates. Existing paid subscribers may cancel their subscriptions to the Napster service for many reasons, including those described above in this risk factor. In addition, there is significant seasonality in our subscriber numbers, primarily due to softness in customer acquisition during the summer months when consumers spend less time online. While we have successfully reduced churn in the past, we cannot guarantee that we will be able to maintain or further reduce subscriber cancellation levels.

If we are unable to add new paid subscribers and retain customers we may be unable to achieve a profitable business model.

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We experience fluctuations in our quarterly operating results, which may cause our stock price to decline.

Our quarterly operating results may fluctuate from quarter to quarter. We cannot reliably predict future revenue and margin trends and such trends may cause us to adjust our operations. Other factors that could affect our quarterly operating results include:

• timing of service introductions;

• consumer adoption of new services;

• seasonal fluctuations in sales of our prepaid cards and bundled hardware promotions, as well as other products and services;

• potential declines in selling prices of music as a result of competitive pressures;

• changes in the mix of our revenues and our users represented by our various services;

• fluctuations in traffic levels on our websites, which can be significant as a result of business, financial and other news events;

• adverse changes in the level of economic activity in the United States or other major economies in which we do business, or in industries, such as the music industry, on which we are particularly dependent;

• expenses incurred in connection with the development of our digital music distribution services;

• expenses related to, and the financial impact of, possible acquisitions of other businesses;

• foreign currency exchange rate fluctuations;

• expenses incurred in connection with strategic partnerships we have entered into or may enter into in the future; and

• fluctuating and unpredictable demand for advertising.

We rely on the value of the Napster brand, and our revenues could suffer if we are not able to maintain its high level of recognition in the digital music sector.

We believe that maintaining and expanding the Napster brand is an important aspect of our efforts to attract and expand our user and advertiser base. We employ a broad branding program to ensure that our position in the digital music sector continues to be strongly associated with the Napster name. Promotion and enhancement of the Napster brand will depend in part on our ability to provide consistently high-quality products and services. If we are not able to successfully maintain or enhance consumer awareness of the Napster brand or, even if we are successful in our branding efforts, if we are unable to maintain or enhance customer awareness of the Napster brand in a cost effective manner, our business, operating results and financial condition would be harmed.

We face significant competition from traditional retail music distributors, from emerging paid online and mobile music services delivered electronically such as ours, and from “free” online and peer-to-peer services.

We face significant competition from traditional retail music distributors, as well as online retailers such as Amazon.com. These retailers may include regional and national mall-based music chains, international chains, deep-discount retailers, mass merchandisers, consumer electronics outlets, mail order, record clubs, independent operators and online physical retail music distributors, some of which have greater financial and other resources than we do. To the extent that consumers choose to purchase media in non-electronic formats, it may reduce our sales, reduce our gross margins, increase our operating expenses and decrease our profit margins in specific markets.

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Our digital music distribution services’ competitors currently include Apple Inc.’s iTunes Music Store, RealNetworks, Inc’s Rhapsody America, Microsoft’s Zune Marketplace and eMusic. Other competitors include online and offline retailers such as Amazon.com and WalMart, satellite radio providers such as XM and Sirius, carrier branded music services offered directly by mobile operators such as Verizon (via its V-cast service) and Sprint (through its Music Store) and music services offered by certain handset manufacturers such as Nokia. We also face competition from general purpose consumer online services such as Yahoo, My Space Music, MSN and Google, each of which provides access to music-related content and services; from websites targeted to music related content, such as Last.fm and pandora.com; and from social networking sites, such as iMeem. Internationally we currently compete with Puretracks, Omnifone’s Music Station, 3 Music Store and Vodafone’s music offerings, among others, as well as with a number of the other competitors described above.

Our digital music distribution business also faces significant competition from “free” peer-to-peer services, such as LimeWire, Kazaa, Morpheus, BitTorrent and a variety of similar services that allow computer users to connect with each other and to copy many types of program files, including music and other media, from one another’s hard drives, all without securing licenses from content providers. While the U.S. Supreme Court has found that Grokster, a former peer-to-peer file sharing program, may have violated copyright laws, the court did not establish that such services are necessarily liable for copyright infringement, opting instead for a fact-based analysis of the services’ efforts to promote copyright infringement. Additionally, enforcement efforts against those in violation have not effectively shut down these services, and there can be no assurance that these services will ever be shut down. We are also impacted by free services operated out of foreign jurisdictions, such as Russia, where copyright and other laws may be less stringently interpreted and/or enforced. The ongoing presence of these “free” services substantially impairs the marketability of legitimate services, regardless of the ultimate resolution of their legal status. Finally, several high profile peer-to-peer services, such as LimeWire, have started to or announced their intention to move to legally (or partially legally) licensed business models, while still using their peer-to-peer architecture. Many of these entities are well financed with significant installed user bases and if they are successful in moving their businesses to legal models, it could significantly increase our competitive pressure.

Many of our competitors have significantly more resources than we do, and some of our competitors may be able to leverage their experience in providing digital music distribution services or similar services to their customers in other businesses. We or our competitors may be able to secure limited exclusive rights to content from time to time. If our competitors secure significant exclusive content, it could harm the ability of our online music services to compete effectively in the marketplace.

In particular, some of our competitors offer other goods and services and may be willing and able to offer music services at a lower price than we can in order to promote the sale of these goods and services. If we lower our prices, our gross margins and operating results may be adversely affected. If we do not lower our prices, we may be unable to compete with discount services. This could harm the ability of our online music services to compete effectively in the marketplace.

Our advertising-supported music website competes, directly and indirectly, for advertisers, viewers, members, and content providers with publishers and distributors of traditional off-line media, such as television, radio and print, including those targeted to music, many of which have established or may establish websites, as well as a number of the entities listed above who provide free or ad-based access to music.

Digital music distribution services in general are new and rapidly evolving and may not prove to be a profitable or even viable business model.

Digital music distribution services are a relatively new business model for delivering digital media over the Internet. It is too early to predict whether consumers will accept, in significant numbers, digital music services and accordingly whether the services will be financially viable. If digital music distribution services do not prove to be popular with consumers, or if these services cannot sustain any such popularity, our business and prospects would be harmed.

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The emerging mobile music market faces significant, unique challenges.

We believe that growth in the mobile music services market is important to the future growth in our general digital music distribution services. We are investing in this area but face significant and unique challenges that could adversely affect our business.

There are a number of challenges that could impact the adoption rate of mobile platforms as a leading method of digital music purchase, including the rate of adoption of compatible mobile handsets, availability of high speed mobile data networks, adoption by mobile consumers of mobile data plans, development of content and digital rights management standards and technologies acceptable to content licensors and consumers, any pricing differential (both wholesale and retail) between content purchased over-the-air to a mobile device and purchased by other means, and the impact on the economics of the mobile music business of certain issued patents.

The success of our mobile music business is also currently contingent upon our ability to enter into strategic partnerships with leading mobile carriers. We cannot guarantee our ability to enter into or maintain these types of relationships. Additionally, certain major mobile carriers and handset manufacturers create and operate their own mobile music services that they offer directly to the consumer. Should this direct-to-consumer model become more prevalent, it could jeopardize our ability to competitively market our services.

If we are unsuccessful in meeting the challenges and complexities of mobile music distribution or are unsuccessful in securing additional customers for our services, our results of operations could be harmed.

We rely on content provided by third parties, which may not be available to us on commercially reasonable terms or at all.

We rely on third-party content providers, including music publishers and music labels, to offer online music content that can be delivered to users of our digital music distribution services. Rights to provide this content to our customers, particularly publishing rights, are difficult to obtain and require significant time and expense. In order to provide a compelling service, we must continue to be able to license a wide variety of music content to our customers with attractive usage rights such as CD recording, output to MP3 players, portable subscription, wireless and other rights. In addition, if we do not have sufficient breadth and depth of the titles necessary to satisfy increased demand arising from growth in our subscriber base, our subscriber satisfaction will be affected adversely.

Under copyright law, we are required to pay licensing fees for compositions embodied in digital sound recordings and for the sound recordings themselves that we deliver in our Napster service. U.S. copyright law generally does not specify the rate and terms of the licenses, which are determined by voluntary negotiations among the parties or, for certain compulsory publishing licenses where voluntary negotiations are unsuccessful, by a copyright royalty board (“CRB”), an administrative judicial proceeding supervised by the United States Copyright Office. Past copyright proceedings have resulted in rates for statutory webcasting that were significantly in excess of rates requested by webcasters. Currently, there is a CRB proceeding for mechanical licenses for digital distribution, including in a subscription context. The parties engaged in the CRB proceeding have agreed to a partial settlement thereof and have asked the judges to approve a process by which they will receive and consider the proposal. However, we cannot predict the outcome of the CRB proceedings. We may also elect to attempt to directly license compositions for our services, either alone or in concert with other affected companies. Further, the continued availability of blanket licenses for compositions used in international versions of the services is not assured, and for certain additional international services may be unclear. Therefore, our ability to negotiate appropriate licenses is uncertain.

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Pending the outcome of the CRB proceeding, we are currently operating under a standstill agreement and the partial settlement mentioned above until rates are finalized. Although a decision has been rendered by a United States district court that permanent downloads do not implicate a performance right that would trigger payment of public performance royalties to societies such as ASCAP or BMI, that decision could be appealed and the performing rights societies have not conceded the argument or entered into any agreements on that basis. In Canada, a recent tribunal ruling fixed certain rates and other requirements that are applicable to our Canadian digital music services. However, there is still some uncertainty with respect to the mechanics of its implementation, the result of which may hinder our ability to operate in Canada. In addition to certain other negotiations, European Union tribunals and/or negotiations are currently in process, which will set rates for subscription music services and services that deliver digital downloads of music, and the outcome of these negotiations and proceedings will also likely affect our business in ways that we cannot predict. Napster accrues for the cost of these fees, based on contracted or statutory rates, when established, or management’s best estimates based on facts and circumstances regarding the specific music services and agreements in similar geographies or with similar agencies. If the final agreed rates differ significantly from management’s estimate, the actual amount paid and expensed could differ materially from the recorded amounts. The differing types and large quantity of licenses that we must obtain creates significant complexities for our business and, as the licensing situation evolves in the different countries in which we operate, these requirements may significantly impact or hinder our ability to execute our business plans.

Our success depends on our digital music distribution services’ interoperability with our customers’ music playback hardware.

In order for the paid Napster service to be successful, we must design our service to interoperate effectively with a variety of hardware products, including PCs, portable MP3 players, music-enabled cell phones and other mobile devices, home stereos, set top boxes and car stereos. We depend on significant cooperation with manufacturers of these products and with software manufacturers that create the operating systems for such hardware devices to achieve our design objectives and to offer a service that is attractive to our customers. Currently, there are a limited number of devices that offer the portable subscription functionality that is required to support our Napster To Go and Napster Mobile services and certain current manufacturers may not be able to profitably continue to offer existing devices. Our subscription service is not currently compatible with the Apple lines of products, which include the iPod music player, the current equipment market leader, and the iPhone. If we cannot successfully design our service to interoperate with the music playback devices that our customers own, or if music-enabled devices fail to grow significantly over time, our business will be harmed.

We may not successfully develop new products and services.

The success of our digital music distribution services will depend on our ability to develop leading-edge media and digital distribution products and services. Our business and operating results will be harmed if we fail to develop products and services that achieve widespread market acceptance or that fail to generate significant revenues or gross profits to offset our development and operating costs. We may not timely and successfully identify, develop and market new product and service opportunities.

Additionally, we may not be able to add new content such as video, spoken word or other content as quickly or as efficiently as our competitors or at all. If we introduce new products and services, they may not attain broad market acceptance or contribute meaningfully to our revenues or profitability. Competitive or technological developments may require us to make substantial, unanticipated investments in new products and technologies, and we may not have sufficient resources to make these investments.

Because the markets for our products and services are changing rapidly, we must develop new offerings quickly. Delays and cost overruns could affect our ability to respond to technological changes, evolving industry standards, competitive developments or customer requirements. Our products also may contain undetected errors that could cause increased development costs, loss of revenues, adverse publicity, reduced market acceptance of our products or services or lawsuits by customers.

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We must maintain and add to our strategic marketing relationships in order to be successful.

We depend on a number of strategic relationships with third parties to co-market our services. We have entered into co-marketing agreements with infrastructure providers, mobile carriers, retailers, hardware manufacturers and other companies to broaden the distribution of our brand and our services. There is no guarantee that we will be able to renew existing agreements or enter into new agreements on acceptable terms, or at all. If we cannot maintain existing strategic relationships or enter into new relationships, our ability to market our services will be harmed.

In addition, because of the rapidly evolving nature of digital music distribution and our short history of operations, we often enter into strategic agreements where the financial impact on our business and operations is uncertain. We cannot guarantee that any of these agreements will result in the desired benefits to our business or result in significant additional revenue.

Our network is subject to security and stability risks that could harm our business and reputation and expose us to litigation or liability.

Online and mobile commerce and communications depend on the ability to transmit confidential information and licensed intellectual property securely over private and public networks. Any compromise of our ability to transmit such information and data securely or reliably, and any costs associated with preventing or eliminating such problems, could harm our business. Online transmissions are subject to a number of security and stability risks, including:

• our own or licensed encryption and authentication technology, and access and security procedures, may be compromised, breached or otherwise be insufficient to ensure the security of customer information or our music content;

• we could experience unauthorized access, computer viruses, system interference or destruction, “denial of service” attacks and other disruptive problems, whether intentional or accidental, that may inhibit or prevent access to our websites or use of our products and services;

• someone could circumvent our security measures and misappropriate our, our partners’ or our customers’ intellectual property, interrupt our operations, or jeopardize our licensing arrangements, which are contingent on our sustaining appropriate security protections;

• our computer systems could fail and lead to service interruptions;

• our mobile partners’ wireless networks or other infrastructure could fail;

• we may be unable to scale our infrastructure with increases in customer demand; or

• our network of facilities may be affected by a natural disaster, terrorist attack or other catastrophic events.

The occurrence of any of these or similar events could damage our business, hurt our ability to distribute products and services and collect revenue, threaten the proprietary or confidential nature of our technology, harm our reputation and expose us to litigation or liability. We may be required to expend significant capital or other resources to protect against the threat of security breaches, hacker attacks or system malfunctions or to alleviate problems caused by such breaches, attacks or failures.

If we fail to manage expansion effectively, we may not be able to successfully manage our business, which could cause us to fail to meet our customer demand or to attract new customers, which would adversely affect our revenue.

Our ability to successfully offer our products and services and implement our business plan in a rapidly evolving market requires an effective planning and management process. We plan to continue to increase the scope of our digital music distribution operations domestically and internationally. This anticipated growth in future operations may place a significant strain on our management resources that could distract management’s attention and result in our failure to execute our business plan.

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We may be unable to adequately protect our proprietary rights.

Our inability to protect our proprietary rights, and the costs of failing to do so, could harm our business. Our success and ability to compete partly depend on the superiority, uniqueness or value of our technology, including both internally developed technology and technology licensed from third parties. To protect our proprietary rights, we rely on a combination of patent, trademark, copyright and trade secret laws, confidentiality agreements with our employees and third parties, and protective contractual provisions. These efforts to protect our intellectual property rights may not be effective in preventing misappropriation of our technology. These efforts also may not prevent the development and design by others of products or technologies similar to, competitive with or superior to those we develop. Any of these results could reduce the value of our intellectual property. We may be forced to litigate to enforce or defend our intellectual property rights and to protect our trade secrets. Any such litigation could be very costly and could distract our management from focusing on operating our business.

A significant portion of the revenues from our digital music distribution business is derived from international revenues. Economic, political, regulatory and other risks associated with international revenues and operations could have an adverse effect on our revenues.

Because we operate in the Americas, Japan and Europe, our business is subject to risks associated with doing business internationally. Revenues from international operations have represented a significant portion of our total net revenues from our digital music distribution business. We anticipate that revenues from international operations will continue to represent a substantial portion of our total net revenues as we expand our Napster and Napster Mobile services abroad and enter into additional joint venture arrangements and other strategic partnerships, if any, with international partners. Accordingly, our future revenues could decrease based on a variety of factors, including:

• disputes with our international joint venture partners;

• dilution of our interest and degree of control over our joint venture;

• mismanagement or fraud by our international joint venture partners;

• changes in foreign currency exchange rates;

• seasonal fluctuations in sales of our prepaid cards as well as other products and services internationally;

• changes in a specific country’s or region’s political or economic condition, particularly in emerging markets;

• unexpected changes in foreign laws and regulatory requirements;

• difficulty of effective enforcement of contractual provisions in local jurisdictions;

• trade protection measures and import or export licensing requirements;

• potentially adverse tax consequences including changes to the VAT collection scheme;

• difficulty in managing widespread sales operations; and

• less effective protection of intellectual property in foreign jurisdictions.

We depend on key personnel who may not continue to work for us.

Our success substantially depends on the continued employment of certain executive officers and key employees, including, for example, Christopher Gorog, our Chief Executive Officer. The loss of their services could harm our business. If they were to leave our company, we could face substantial difficulty in hiring a qualified successor and could experience a loss in productivity while any such successor obtains the necessary training and experience.

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To grow our business, we must be able to hire and retain sufficient qualified technical, sales, marketing and administrative personnel.

Our future success depends in part on our ability to attract and retain engineering, sales, marketing, finance, administrative and customer support personnel. If we fail to retain and hire a sufficient number of these employees, we will not be able to maintain and expand our business. We cannot assure you that we will be able to hire and retain a sufficient number of qualified personnel to meet our business objectives.

We may be subject to intellectual property infringement claims, which are costly to defend and could limit our ability to use certain technologies in the future.

Many parties are actively developing streaming media and digital distribution-related technologies, e-commerce and other web-related technologies, as well as a variety of online business methods and models. We believe that these parties will continue to take steps to protect these technologies, including, but not limited to, seeking patent protection. As a result, disputes regarding the ownership of these technologies and rights associated with streaming media, digital distribution and online businesses are likely to arise in the future and may be very costly. In addition to existing patents and intellectual property rights, we anticipate that additional third-party patents related to our products and services will be issued in the future. If a blocking patent has been issued or is issued in the future, we would need to either obtain a license or design around the patent. We may not be able to obtain such a license on acceptable terms, if at all, or design around the patent, which could harm our business.

Companies in the technology and content-related industries have frequently been subjected to litigation regarding intellectual property rights. In addition, we believe these industries are experiencing an increased level of litigation to determine the applicability of current laws to, and the impact of new technologies on, the use and distribution of content over the Internet and through new devices, especially in the music industry. From time to time, we receive claims and inquiries from third parties alleging that our internally developed technology, or technology we license from third parties, may infringe their proprietary rights, especially patents. Third parties have also asserted and most likely will continue to assert claims against us alleging infringement of copyrights, trademark rights, or other proprietary rights, or alleging unfair competition or violations of privacy rights. As we continue to develop and introduce products and services that provide or enable the provision of content, our litigation risk may increase. As a result, we could be required to spend significant amounts of time and money to defend ourselves against such claims. If any of these claims were to prevail, we could be forced to pay damages, comply with injunctions, or stop distributing our products and services while we re-engineer them or seek licenses to necessary technology, which might not be available on reasonable terms, or at all. We could also be subject to claims for indemnification resulting from infringement claims made against our customers and strategic partners, which could increase our defense costs and potential damages. Any of these events could require us to change our business practices and could harm our business.

A decline in current levels of consumer spending could reduce our sales.

Our business is directly affected by the level of consumer spending. One of the primary factors that affects consumer spending is the general state of the local economies in which we operate. Lower levels of consumer spending in regions in which we have significant operations could have a negative impact on our business, financial condition or results of operations.

We may need additional capital, and we cannot be sure that additional financing will be available.

Although we currently anticipate that our available funds and expected cash flows from operations will be sufficient to meet our cash needs for at least the next twelve months, we may require additional financing. Our ability to obtain financing will depend, among other things, on our development efforts, business plans, operating performance and condition of the capital markets at the time we seek financing. We expect to experience operating losses from our digital music distribution business in at least the short-term. We cannot assure you that additional financing will be available to us on favorable terms when required, or at all. If we raise additional funds through the issuance of equity, equity-linked or debt securities, those securities may have rights, preferences or privileges senior to the rights of our common stock, and our stockholders may experience dilution.

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We are subject to risks associated with governmental regulation and legal uncertainties.

Few existing laws or regulations specifically apply to the Internet, other than laws and regulations generally applicable to businesses. Certain United States export controls and import controls of other countries, including controls on the use of encryption technologies, may apply to our products. Many laws and regulations, however, are pending and may be adopted in the United States, individual states, and local jurisdictions and other countries with respect to the Internet. In addition, as we conduct more business via mobile platforms in multiple countries, our business will likely be impacted by additional laws and regulations that are applicable to the mobile space. These laws may relate to many areas that impact our business, including content issues (such as obscenity, indecency and defamation), copyright and other intellectual property rights, digital rights management, encryption, caching of content by server products, personal privacy, taxation, e-mail, sweepstakes, promotions, prepaid card expiration, escheatment, network and information security and the convergence of traditional communication services with Internet communications, including the future availability of broadband transmission capability and wireless networks. These types of regulations are likely to differ between countries and other political and geographic divisions. Other countries and political organizations are likely to impose or favor more and/or different regulations than that which has been proposed in the United States, thus furthering the complexity of regulation. In addition, state and local governments may impose regulations in addition to, inconsistent with, or stricter than federal regulations. The adoption of such laws or regulations, and uncertainties associated with their validity, interpretation, applicability and enforcement, may affect the available distribution channels for and costs associated with our products and services and may affect the growth of the Internet. Such laws or regulations may harm our business. Our products and services may also become subject to investigation and regulation of foreign data protection and e-commerce authorities, including those in the European Union. Such activities could result in additional product and distribution costs for us in order to comply with such regulations.

We do not know for certain how existing laws governing issues such as property ownership, copyright and other intellectual property issues, digital rights management, taxation, security, illegal or obscene content, retransmission of media, personal privacy and data protection apply to the Internet. The vast majority of such laws were adopted before the advent of the Internet and related technologies and do not address the unique issues associated with the Internet and related technologies. Most of the laws that relate to the Internet have not yet been interpreted. In addition to potential legislation from local, state and federal governments, labor guild agreements and other laws and regulations that impose fees, royalties or unanticipated payments regarding the distribution of media over the Internet may directly or indirectly affect our business. While we and our customers may be directly affected by such agreements, we are not a party to such agreements and have little ability to influence the degree to which such agreements favor or disfavor Internet distribution or our business models. Changes to or the interpretation of these laws and the entry into such industry agreements could:

• limit the growth of the Internet;

• create uncertainty in the marketplace that could reduce demand for our products and services;

• increase our cost of doing business;

• expose us to increased litigation risk, substantial defense costs and significant liabilities associated with content available on our websites or distributed or accessed through our products or services, with our provision of products and services and with the features or performance of our products and websites;

• lead to increased product development costs or otherwise harm our business; or

• decrease the rate of growth of our user base and limit our ability to effectively communicate with and market to our user base.

The Child Online Protection Act and the Child Online Privacy Protection Act impose civil and criminal penalties on persons distributing material harmful to minors (e.g., obscene material) over the Internet to persons under the age of 17, or collecting personal information from children under the age of 13. While we do not knowingly distribute harmful materials to minors or collect personal information from children under the age of 13, the manner in which these Acts may be interpreted and enforced cannot be fully determined, and future legislation similar to these Acts could subject us to potential liability if we were deemed to be non-compliant with such rules and regulations, which in turn could harm our business.

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There are a large number of legislative proposals before the United States Congress and various state legislatures regarding intellectual property, digital rights management, copy protection requirements, privacy, email marketing and security issues related to our business. Furthermore, as part of our regular business activities now, and in the past, we engage in the issuance of gift cards redeemable for our services. It is possible that money received by us for the sale of gift cards could be subject to state and federal escheatment, or unclaimed property, laws in the future. If this were the case, our business could be adversely impacted. It is not possible to predict whether or when such legislation may be adopted, and certain proposals, if adopted, could materially and adversely affect our business through a decrease in user registration and revenue, and influence how and whether we can communicate with our customers.

We may be subject to assessment of additional sales and other taxes for the sale of our products, license of technology or provision of services.

We do not currently collect sales or other taxes on the sale of our products, license of technology or provision of services in states and countries other than those in which we have offices or employees. Our business would be harmed if one or more states or any foreign country were to require us to collect sales or other taxes from past sales or income related to products, licenses of technology or provision of services.

We may be subject to market risk and legal liability in connection with the data collection capabilities of our products and services.

Many of our products are interactive Internet or mobile applications which by their very nature require communication between a client and server to operate. To provide better consumer experiences and to operate effectively, our products send information to servers. Many of the services we provide also require that a user provide certain information to us. We post an extensive privacy policy concerning the collection, use and disclosure of user data involved in interactions between our client and server products. Any failure by us to comply with our posted privacy policy and existing or new legislation regarding privacy issues could impact the market for our products and services, subject us to litigation and harm our business.

If, in the future, we conclude that our internal control over financial reporting is not effective, or if our auditors conclude that our internal control over financial reporting is not effective, investors could lose confidence in the reliability of our financial statements, which could result in a decrease in the value of our common stock.

As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission (“SEC”) adopted rules requiring public companies to include a report of management on the company’s internal control over financial reporting in their annual reports on Form 10-K. This report is required to contain an assessment by management of the effectiveness of such company’s internal control over financial reporting. There is a risk that in the future we may identify internal control deficiencies that suggest that our controls are no longer effective. This could result in an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements, which could cause the market price of our common stock to decline and make it more difficult for us to finance our operations.

The effectiveness of our disclosure and internal controls may be limited.

Our disclosure controls and procedures and internal control over financial reporting may not prevent all errors and misrepresentations. In the event that there are errors or misrepresentations in our historical financial statements or the SEC disagrees with our accounting, we may need to restate our financial statements. For example, in November 2004 we restated our financial statements in order to correct the valuation of a previously issued warrant and to adjust the purchase accounting of our former subsidiary, MGI Software, and in May 2005 we restated our financial statements to reallocate the tax benefit of certain operating losses from our discontinued operations to our continuing operations. Any system of internal controls can only provide reasonable assurance that all control objectives are met. Some of the potential risks involved could include, but are not limited to, management judgments, simple errors or mistakes, willful misconduct regarding controls or misinterpretation. There is no guarantee that existing controls will prevent or detect all material issues or be effective in future conditions, which could materially and adversely impact our financial results in the future.

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Provisions in our agreements, charter documents, stockholder rights plan and Delaware law may delay or prevent acquisition of us, which could decrease the value of our stock.

Our certificate of incorporation and bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us without the consent of our board of directors. These provisions include a classified board of directors and limitations on actions by our stockholders by written consent. In addition, our board of directors has the right to issue preferred stock without stockholder approval, which could be used to dilute the stock ownership of a potential hostile acquirer. Delaware law also imposes some restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding common stock. In addition, we have adopted a stockholder rights plan that makes it more difficult for a third party to acquire us without the approval of our board of directors. Although we believe these provisions provide for an opportunity to receive a higher bid by requiring potential acquirers to negotiate with our board of directors, these provisions apply even if the offer may be considered beneficial by some stockholders.

Negative conditions in the global credit markets may impair the liquidity of our investment portfolio.

We invest our cash in a variety of financial instruments, consisting principally of investments in commercial paper, corporate securities, U.S. agencies securities, asset-backed securities and money market funds. These investments are subject to general credit, liquidity, market and interest rate risks, which may be exacerbated by unusual events, such as the sub-prime mortgage crisis in the United States that has affected various sectors of the financial markets and led to global and liquidity issues. If the global credit market continues to deteriorate, our investment portfolio may be impacted and we could determine that some of our investments are impaired.

In particular, our investments include one AAA rated auction-rate security of $2.7 million estimated fair value. The underlying assets of this security are student loans generally guaranteed by the U.S. government. The recent negative conditions in the global credit markets have prevented most investors from liquidating their holdings of auction rate securities, because the amount of securities submitted for sale has exceeded the amount of purchase orders for such securities. If the credit market does not improve, auctions for our invested amounts may fail. If an auction fails for a security in which we have invested, we may be unable to liquidate our auction rate security at par, should we need or desire to access the funds invested in that security. In the event we need or desire to access these funds, we will not be able to do so until a future auction on this investment is successful or a buyer is found outside the auction process. If a buyer is found but is unwilling to purchase the investment at par, we may incur a loss. As of June 30, 2008, the estimated fair value of the auction-rate security was less than par. We have an unrealized loss of $300,000 due to the temporary decline in the value of this security. Future rating downgrades of the security issuer or the third-parties insuring such investments may require us to continue to adjust the carrying value of these investments down due to possible future declines in value.

We may be required to recognize impairment charges related to goodwill and amortizable intangible assets.

Our goodwill or amortizable intangible assets may become impaired and we may be required to record a significant charge to earnings. We test our goodwill for impairment at least annually and we review our amortizable intangible assets for impairment whenever events or changes in circumstances indicate the carrying value may not be recoverable. Factors that may be considered a change in circumstances indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable include a decline in stock price and market capitalization, future cash flows, and slower growth rates in our industry. We may be required to record a significant charge to earnings in our financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is identified resulting in an impact on our results of operations.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

(c) In accordance with the terms applicable to restricted stock awards to our employees, we require our employees to deliver shares of our common stock to us in order to satisfy any applicable tax withholding requirements that arise in connection with the vesting of their restricted stock awards. During the three months ended June 30, 2008, our employees delivered 202,275 shares of our common stock to us to satisfy tax-withholding obligations with respect to restricted stock awards that vested during such period.

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ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

Exhibits

The exhibits listed on the Exhibit Index (following the Signatures section of this report) are included, or incorporated by reference, in this Quarterly Report.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned thereunto duly authorized.

	NAPSTER, INC.
	(Registrant)
Date: August 11, 2008	By:	/s/ WM. CHRISTOPHER GOROG
		Wm. Christopher Gorog
		Chief Executive Officer
		(Principal Executive Officer)
	By:	/s/ SUZANNE M. COLVIN
		Suzanne M. Colvin
		Vice President, Finance and Interim
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

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INDEX TO EXHIBITS

Exhibit Number	Description of Exhibit
2.1	Purchase Agreement among the Registrant, UMG Duet Holdings, Inc., a Delaware corporation, and SMEI Duet Holdings, Inc., a Delaware corporation, dated May 19, 2003 (1)
2.2	AOL Asset Purchase Agreement by and between AOL LLC, AOL Music Now LLC and Napster, LLC, dated January 11, 2007, excluding certain schedules, exhibits, appendices and annexes thereto (2) **
2.3	Amendment No. 1 to AOL Asset Purchase Agreement by and between AOL LLC, AOL Music Now LLC and Napster, LLC, dated March 14, 2007, excluding certain schedules, exhibits, appendices and annexes thereto (2)
2.4	Letter Agreement, dated March 14, 2007, amending that certain AOL Asset Purchase Agreement by and between AOL LLC, AOL Music Now LLC and Napster, LLC, dated January 11, 2007, as amended (2)
3.1	Amended and Restated Certificate of Incorporation of the Registrant (4)
3.2	Amended and Restated Bylaws of the Registrant (11)
3.3	Certificate of Designation of Rights, Preferences and Privileges of Series A Participating Preferred Stock of Roxio, Inc. (6)
4.1	Form of Common Stock certificate of the Registrant (3)
4.2	Preferred Stock Rights Agreement, dated as of May 18, 2001, between Registrant and Mellon Investor Services, LLC, including the Certificate of Designation, the form of Rights Certificate and the Summary of Rights attached thereto as Exhibits A, B, and C, respectively (6)
4.3	Form of Purchase Agreement dated as of June 18, 2003 by and between the Registrant and certain Purchasers set forth on the signature page thereto (7)
4.4	Amended and Restated LLC Operating Agreement of Napster, LLC dated May 19, 2003 by and between Registrant, UMG Duet Holdings, Inc. and SMEI Duet Holdings, Inc. (5)
4.5	Form of Purchase Agreement dated as of January 13, 2004 by and between Napster and certain Purchasers set forth on the signature page thereto (8)
4.6	Registration Rights Agreement dated June 17, 2004 between the Registrant and Best Buy Enterprise Services Inc. (9)
4.7	Common Stock Purchase Agreement between Registrant and Best Buy Enterprise Services Inc. dated June 17, 2004 (9)
4.8	Form of Purchase Agreement dated as of January 20, 2005 by and between Registrant and certain Investors (10)
10.1	Letter Agreement, dated July 2, 2008, between the Company and Suzanne M. Colvin* (12)
31.1	Certification of Chief Executive Officer required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

* Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to applicable rules of the Securities and Exchange Commission.

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** Pursuant to 17 CFR 240.24b-2, confidential information has been omitted and has been filed separately with the Securities and Exchange Commission pursuant to a Confidential Treatment Application filed with the Commission.

(1) Incorporated by reference to the Registrant’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on May 19, 2003.

(2) Incorporated by reference to the Registrant’s Annual Report on Form 10-K as filed with the Securities and Exchange Commission on June 6, 2007.

(3) Incorporated by reference to the Registrant’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on December 23, 2004.

(4) Incorporated by reference to the Registrant’s Form 10 Registration Statement (No. 000-32373) as filed with the Securities and Exchange Commission on May 15, 2001.

(5) Incorporated by reference to the Registrant’s Annual Report on Form 10-K as filed with the Securities and Exchange Commission on June 30, 2003.

(6) Incorporated by reference to the Registrant’s Registration Statement on Form 8-A as filed with the Securities and Exchange Commission on June 5, 2001.

(7) Incorporated by reference to the Registrant’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on June 20, 2003.

(8) Incorporated by reference to the Registrant’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on January 13, 2004.

(9) Incorporated by reference to the Registrant’s Registration Statement on Form S-3 (No. 333-117520) as filed with the Securities and Exchange Commission on July 20, 2004.

(10) Incorporated by reference to the Registrant’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on January 21, 2005.

(11) Incorporated by reference to the Registrant’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on December 14, 2007.

(12) Incorporated by reference to the Registrant’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on July 2, 2008.

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