Dueling Fools Dueling Fools
March 25, 1998

N2K Bull's Pen
Louis Corrigan (tmfseymor@aol.com)

Sure, call it Internet-a-gaga. The recipe seems simple. Throw together an Internet business selling just about anything. Select from the crew of investment bankers hankering to take you public. Use the cash to sign multimillion dollar leases for key online real estate. Then watch your stock get caught up in the hype along with the Amazon.coms (Nasdaq: AMZN) and America Onlines (NYSE: AOL) of the world. And just pray the bubble doesn't burst before you get a chance to sell more shares for "estate planning purposes." The spice to the recipe? No, not Ginger. How about... convince investors that current earnings don't matter -- and neither do current sales. Now that's scary.

If you guffaw at the valuations afforded many Internet companies, then online music retailer and entertainment company N2K is probably one target of your derision. For FY97, N2K's revenues rose nearly 600%... to $11.3 million. Yet N2K took advantage of the millions of dollars raised in its October IPO to, well, spend a bunch of them. As a result, the company lost $28.7 million for the year. And analysts see losses for at least the next two years. So what's the valuation? Pricey by standard methodologies.

By my calculations, N2K will soon have 17.6 million common share equivalents outstanding (issued shares plus in-the-money options and warrants), assuming that both the recently announced secondary offering (two million new shares) plus the overallotment (0.57 million new shares) occur. If you back out the company's net cash after the offering ($124 million, assuming current options and warrants are exercised) from the roughly $422 million market cap, you get an enterprise value of around $300 million. An enterprise value-to-sales ratio of 26.5 doesn't sound cheap in itself or in relation to the 21.3 EV/sales ratio sported by competitor CDnow (Nasdaq: CDNW), which has a 24% higher adjusted enterprise value but all of $17.4 million in FY97 sales. By contrast, successful music retailer Trans World Entertainment (Nasdaq: TWMC) turned in FY97 sales of $571 million but trades at an EV/sales ratio of just 0.92!

So why am I bullish?

Investors need to either ignore Internet companies or learn how to value them. In the short term, the keys are access to capital, branding, online real estate, partnerships, and eyeballs. Longer term, the issues are the quality of management and whether the business really makes Internet sense. If a company can survive the short term and it meets the longer-term requirements, then you need to start valuing the business based on what it will be worth five years out. That's what the market is prepared to do, and rightly so given the power of the medium to transform old businesses that we thought we knew.

Selling CDs and related products online makes great sense. N2K's catalog of 550,000 titles offers 10 times more options than even well-stocked music stores like Tower Records. With no brick-and-mortar stores and no inventories, N2K is immediately in the market's sweet spot along with CDnow. How sweet? Amazon.com even wants into the business. If the economics of the market are good enough for Amazon CEO Jeff Bezos, they're good enough for me. And depending on whom you listen to, revenues from online music sales will reach $1.8 billion (Jupiter Communications) to $4 billion (Forrester Research) by 2002, up from maybe $130 million last year. As for management, Larry Rosen, Dave Grusin, Jon Diamond, and Philip Ramone combine decades of music industry experience with previous entrepreneurial and managerial success.

Shorter term, N2K's Music Boulevard (www.musicblvd.com) brand strikes me as less functional and harder to remember than a CDnow.com or Amazon.com. And where Amazon has got the killer online consumer retail brand, CDnow recently launched a terrific radio campaign to follow-up on its savvy sponsorship of the Grammys. But N2K will be a player for one reason: it has AOL! Last September, N2K spent a minimum of $18 million to become AOL's exclusive music retailer in the online service's MusicSpace and within applicable areas on AOL's website. The deal requires N2K to share sales and advertising revenues with AOL, but it's good for three years, a lifetime in the world of Internet commerce. Given the power of AOL to deliver customers (12 million and counting) for the likes of Tel-Save Holdings (Nasdaq: TALK), this deal should single-handedly ensure N2K's future.

On top of that, N2K has partnered with Netscape, Excite, MTV/VH-1, WebTV, @Home, Country Music Television, and others. The company has also moved impressively to establish itself as an international business, signing a recent deal with Japanese distributor Shinseido to add 200,000 Japanese titles to its offerings and pacts with European distributors that will add 150,000 European language titles. International sales accounted for 26% of N2K's total revenues last year.

Partly because N2K is employing multiple websites connected to its Music Boulevard site, Media Metrix recently deemed it the fastest growing music site on the Internet, with 49.1 million page views in the fourth quarter, up from 39.6 million in the third quarter and 10.4 million a year ago. In November, Music Boulevard reached 1.5% of online surfers. That figure jumped 47% in December to 2.2%, making it the 18th fastest growing site on the Internet. Those numbers will build the brand, and the brand will ensure that N2K won't suffer due to lack of capital.

So what will N2K be worth in five years? C.E. Unterberg, Towbin analyst Adam Giansiracusa projects sales will hit $58 million this year and $199 million in FY99. Assuming Forrester is right, and N2K claims just 12% of the online music market, sales will rise 112% a year to $480 million in FY2002. Trans World now maintains 37% gross margins, but suffers through selling, general and administrative expenses amounting to 27% of sales. Both should be compressed for N2K, but the result will be much stronger profitability than the 3.6% margins sported by Trans World. Add a premium to N2K shares because mindshare on the Internet is worth more than in the "real" world, and it's not crazy to imagine the company's enterprise value at $1.2 billion five years from now, for an enterprise value-to-sales ratio around 2.5. Assume 20 million shares outstanding, and you're looking at a $60 stock, or 20% cumulative annual price appreciation from here.

N2K remains risky, of course, because its current price discounts so much future growth. But the Internet is transforming the way we live and shop, and N2K has positioned itself to benefit from that trend. So 20% per year share appreciation may prove conservative. And in case that sounds like bunk, my conservative three-year price target for Amazon, set two months ago, has already been taken out!

Next: The Bear Argument

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