March 25, 1998
N2K Bear's Den
Rick Munarriz ([email protected])
Let me start with the ugly, because, believe me, things get even uglier. Last year N2K lost $28.7 million on sales of just $11.3 million. Growing pains? Hardly. Music Boulevard is a one-way street -- paved in red and heading downhill.
"Cute Rick, but e-commerce is huge and N2K is going to make a ton of money." When? I have every reason to believe that sales will continue to rise. I do. Yet the company is years away from breaking even and I'll show my math. Recorded music falls victim to razor thin margins. In N2K's case, last quarter gross margins were a mere 9%. Operating expenses were a whopping $13.3 million.
These expenses will no doubt climb over time, and even if we assume they were to remain at these levels, with those meager 9% gross margins the company would have to generate quarterly sales of $150 million just to break even. That is $600 million over the course of the year. Remember, we already covered that N2K only sold $11.3 million last year. Can N2K's sales rise 53-fold?
Cacophony! An interesting piece of optimism comes from Forrester Research, predicting that 30% of all music purchases, or $4 billion, will come from online transactions by the year 2002. So, if an investor is patient enough to park her money in N2K for four years, the rewards should be plentiful. Right? Not quite. Presently, annual sales are in the $130 million range for the youthful industry. With N2K's piece being just 8.7%.
You see, Music Boulevard is not even the most traveled thoroughfare. CDNow had sales of $17.4 million last year and with better-branded companies like Tower Records and Columbia House peddling online CDs, N2K is a small fry. This is not an aural Amazon.com (Nasdaq: AMZN). So, even if annual sales hit $4 billion in four years, if N2K is lucky enough to maintain that 8.7% share of the market it will only report sales of $350 million. Profits, like vinyl, will still be a hard to find novelty. Gross profit margins would have to double for black ink, and the very nature of the record business makes that an unlikely scenario.
Electronic superstores like Best Buy and Circuit City began using CDs as loss leaders. Like supermarket milk, the goods were marked down to almost promotional status in hopes that it would draw patrons in to then buy larger appliances. Overnight, $15 CDs became $12 discs, and it wasn't the record companies that assumed the markdowns. Why do you think Viacom wants to ditch Blockbuster Music? Why is it that the once popular local music chain in your city went under?
Clearly the retailing of prerecorded music is not as lucrative as it used to be. But even if gross margins were to improve for N2K, to say 15% -- which the company had achieved earlier in the year, and as the company grows some economies of scale it may allow for this again -- N2K would still not turn a profit on those $350 million in sales with current operating expenses. That's current expenses now, because as the company grows, so will the fixed overhead -- and the bar to profitability.
Can N2K take a larger share of the market? I don't see how. The Musicland and Sam Goody's of the world have yet to make an impact on the Internet, and if the $4 billion dowry is there to be had you can rest assured that the popular brick and mortar chains will be online soon. Even Amazon is entering the fray. Media Metrix may have called Music Boulevard the fastest growing music website, but this is a segment that, despite poor economics, is getting more and more crowded every passing day.
So how is a no-name company going to create a presence? Fresh Picks. These will be interactive touch-screen kiosks that will allow patrons to physically order CDs that will then be mailed to the person. In theory, interesting. In reality, a head-on collision. Because CDs are competitively priced just about everywhere, N2K will be putting these costly contraptions into the only venue that doesn't already stock CDs -- supermarkets.
Between Froot Loops and Colgate, with shoppers rushing in with an agenda and rushing out with their hands full, will they really take the time to navigate the kiosk by the gumball machine?
N2K is also hoping to create brand equity by paying for banner space on popular websites. It's a sound strategy, but Tower Records has been selling on AOL for years and you can't find better entrenched Net peddlers than Amazon.com.
I think this would be a great time to sell N2K, and apparently the company thinks so too. Flush with cash from the October offering, the company is going to now have a 3.8 million share secondary offering, with nearly half of those shares being sold by insiders. N2K -- unplugged.
Next: The Bull Responds