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Tuesday, June 23, 1998

(Nasdaq: CDNW)
Phone: 215-517-7325
Website: http://www.cdnow.com
Price (6/22/98): $17 5/8


The Vapors. Dexy's Midnight Runners. Woe is the life of the one-hit wonder. Like many of the musical flashes in the pan of the 1980s, CDnow has tasted brief overnight success only to squander it. The world's largest online pre-recorded music seller came public at $18 a share just three months ago and never looked back. Fame. Fortune. Excess. Burnout.

After seeing the stock peak at $39, investors figured the amped-up share price was due for an all-acoustic set and the stock was unplugged.

With even the more optimistic analysts expecting steep losses for years, knowing that the payday would be a long time in coming did not necessarily scare away investors. Shareholders of other Internet companies had been rewarded recently during the profitless brand building time of Internet leaders like Amazon.com (Nasdaq: AMZN) and the hot search engines.

This time the demise was niche-specific. The projected deficits have been widening recently as Wall Street is beginning to realize the uphill battle the music retailers have ahead of them. Selling CDs offline is hard enough considering the slim margins pre-recorded music generates. Online, where the competition is just a click away, it has become even more difficult, and any cost advantages that selling virtually may have garnered have been wasted on the promotional expense to keep websites visible. While sales have gone from $6.3 million in 1996 to $17.4 million last year, that amazing growth rate has been outdone by the net loss that has gone from $1.8 million to $10.7 million during that time -- and has widened even further so far this year.

Even worse is the fact that during CDnow's brief public tenure the number of competitors has grown significantly. Columbia House, K-tel (Nasdaq: KTEL), and even Amazon.com are now online music merchants. The question used to be how large will the "e-tail" music market pie become. Now the question is how thin each slice will have to be cut.


Twin brothers Jason and Matthew Olim started CDnow in 1994. The company offers more than 250,000 music-related items on its namesake website. The company does not handle the merchandise. Orders are sent to CDnow and then they are shipped directly from the distributors. The site also provides industry-based content through alliances with Rolling Stone, MTV, and VH-1.

Earlier this year the Pennsylvania-based company acquired superSonic Boom, an online service that provides customized CDs based on customer title selections.


Income Statement
12-month sales: $24.8 million
12-month income: ($19.4 million)
12-month EPS: ($2.13)
Profit Margin: N/A
Market Cap: $211.5 million

Balance Sheet
Cash: $60.5 million
Current Assets: $63.6 million
Current Liabilities: $7.5 million
Long-term Debt: $1.0 million

Price-to-earnings: N/A
Price-to-sales: 8.5


You want cocky? Just two months after CDnow went public the company announced a secondary offering. In the music world, a band will be quick to put out a follow-up release after a hit single, but in the stock market? The company certainly didn't need the fiscal fruits of a dilutive offer. The company was placing greed above need and it did not sit well with investors.

While even fellow online music vendor N2K (Nasdaq: NTKI) followed its own initial public offering with a secondary when the stock was hot, like most companies who have the luxury of being able to transform a rising share price into a money mint, it at least waited for the season to change.

The rushed underwriting may have signaled that even the company knew that life in the $30s would be short-lived. Unfortunately for CDnow, that proved to be the case -- and as the stock tanked in the weeks that followed the announcement, the company did the right thing by calling off the offering.


A sign of the mindshare hungry times: Throughout June CDnow is offering $10 off any $20 or more purchase. Certainly the company is going to lose money on the enterprising shopper who orders just two CDs for almost the price of one. But today is not about profits. Music Boulevard, CDnow's closest competitor, has slashed prices for its "Summer Blockbuster Sale," while K-tel Express launched a new site last month giving away its signature compilations to early customers.

Right now it's a battle of marketing might as the online vendors try to set themselves apart from the rest. I'll admit it, I made my first ever CDnow purchase this month to cash in on the sweet offer. But with June coming to a close, what will the company do to keep me loyal in July?

Clearly the biggest threat is Amazon.com. The company has sold $219.3 million in books online during this past year and has now entered the music arena. With CDnow the market leader with less than $25 million in trailing sales, it seems like only a matter of time before it is unseated at the helm.

Amazon's entry also poses an interesting dilemma. CDnow and Music Boulevard parent N2K had been busy lining up exclusive sponsorship deals on the popular search engines. That was what was supposed to set them apart from new competition when the better-recognized mall record shops came online. But Amazon is already a presence on many of these "exclusive" sites. If not Amazon, then Barnes & Noble (NYSE: BKS) has the multi-year lock on the site, and it may be just a matter of time before it, too, begins ringing up compact disc sales.

The term exclusivity now seems lost in the translation, and by the time CDnow eventually weans its customers from the monthly promos, will it be any better off than when the promo campaigns began? Maybe lesser capitalized players like K-tel will be out of the online niche by then, but will it be too late for a one-hit wonder to stage a revival?

-Rick Aristotle Munarriz

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