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2HRS2GO: AOL renders CDNow irrelevant for Columbia House

CDNow (Nasdaq: CDNW) CEO Jason Olim says the merger died because Columbia House's fiscal 2000 numbers stink.

Columbia House says it's hitting its internal targets and blames government regulators for holding up the deal.

The market is saying Adios to online music retailer CDNow, whose already-battered stock price took more hits following the cancellation of a marriage with Columbia House. CDNW shares have fallen more than 30 percent from Friday's close.

Pardon me if I harbor wholly unfounded, completely speculative and entirely made-up theories to explain the demise of this deal. I just have a hard time believing either side in this story.



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Jason Olim says Columbia House's 1999 financial results missed expectations by a "significant" amount, casting doubt on the company's ability to subsidize CDNow's operations until profitability.

"When we entered (the deal) with Columbia House, we had expected they would have adequate cash to fund our growth," Olim told Reuters. "All of us learned in the last 30 days that its cash flow position and debt level were not what we thought it would be."

Unfortunately, you can say the same thing about CDNow, which missed analyst expectations in the fourth quarter.

On a broader note, it's difficult to take things seriously when CDNow accuses anyone else of disappointing finances. This is the company that said merging with N2K would reduce expenses. About a year ago, an analyst with one brokerage firm that no longer covers CDNow said the music seller's acquisition cost per customer would fall dramatically once the client base hit the 2.5 million to 3 million mark.

It didn't happen. CDNow's total cumulative customers rose to 3.2 million in the latest quarter reported, yet gross margins slid 189 basis points year-over-year because the company offered free shipping. CDNow says that program has since ended, but the fact remains: things didn't get cheaper.

As for blaming regulators, who is Columbia House kidding? This is the same government that approved every Baby Bell merger and dot-com acquisition so far, and is expected to sign off on WorldCom-Sprint (WCOM, FON) and AOL Time Warner. Does anyone really think the Federal Communications Commission would have strong objections to the marriage of two companies with relatively small shares of the overall music retail space? The Wall Street Journal quotes unattributed sources as saying the merger was likely to be approved.

So why is this merger dead? Who knows for certain, but ponder this: what was the strategic rationale for this deal?

For CDNow, it was cash, access to Columbia House's large database of customers and hopes for increased traffic driven by Columbia House's parents, Time Warner (NYSE: TWX) and Sony (NYSE: SNE). Those reasons remain valid, which is why CDNow is looking for another prospective buyer.

For Columbia House, the merger was about better Internet distribution, through a stronger brand than the 'Total E' franchise that few people seem to remember. Nine months ago, CDNow looked like the best Web platform available for Columbia House.

That's not true anymore. And I suspect that's why the merger dissolved.

Let's see, who is Time Warner trying to merge with again? What was that company's name? Oh yeah, that America Online (NYSE: AOL) thing. It's kind of big, right?

Not that there's any guarantee AOL Time Warner will actually happen, given the plunge in AOL's share price. But AOL might be winning over skeptics; the stock has climbed more than 23 percent in the last three weeks, though it remains far below its level before the Time Warner announcement.

Assuming AOL Time Warner passes muster, Columbia House can shovel CDs through AOL's network. Why bother with a cash-hungry outfit like CDNow when the largest distribution platform on the planet is going to own a piece of you?

Maybe CDNow could still fit as a internal cog in the AOL Time Warner machine, rather than merely partnering with it. But is buying CDNow outright worth the expense? Aside from the initial purchase price, AOL Time Warner faces a deep money pit with CDNow. Even with the funding provided by Time Warner and Sony in lieu of the merger, CDNow only has enough cash to last into next year at its current burn rate. Not exactly an appealing scenario for any prospective buyer, let alone a careful company like AOL.

Olim says his company will cut costs by a third, chiefly in the area of advertising and coupons. Slashing expenses creates more breathing room, but the mere fact that CDNow continues to look for an acquirer says all you need to know about the company's viability.

If CDNow truly had a profitable model, it would forget the distractions of a sale and focus on building the business, much as Lycos (Nasdaq: LCOS) did following the collapse of last year's USA Networks (Nasdaq: USAI) proposal. To its credit, Lycos in its latest quarter posted a profit, excluding amortization and one-time charges.

Meanwhile, CDNow searches for a replacement sugar daddy.

Other issues:

  • Nortel Networks
  • (NYSE: NT) What is an investor to make of a $3.25 billion stock purchase of a privately-held company whose product won't even go into production until next year? You can't even find a good basis of comparison, because competing optical switches from the likes of Lucent (NYSE: LU) also won't debut for several months.

    The Xros-1000 switch sounds great -- Xros claims a capacity of more than 1,000 wavelengths, versus 256 for the Lucent switch expected at year's end -- but you have to take the companies' word for it. Once the technology is proven in the field, you still can't evaluate the deal until you get an idea of pricing, availability and service providers' upgrade schedules.

    Perhaps when your stock is trading near an all-time high, you can afford to be generous with it. In fact, you have to be generous in today's environment, with every network equipment maker following the model of Cisco Systems (Nasdaq: CSCO) and buying new technology the moment it appears.

    But Cisco, though its technology choices can be debated, still has the sneakier strategy: leverage tight relationships with Silicon Valley VCs and use them to get in on the ground floor rather than pay billions in stock later on. 22GO>