CDNow flounders following failed merger

Once riding the rising tide for e-commerce issues, companies such as CDNow watch their shares sink as deals fall through and investors look toward other opportunities.

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Like an unsuccessful album tossed into a music store's clearance bin, shares of online retailer CDNow are trading at a steep discount.

A months-long slide in shares was continued this week after the music e-tailer announced that a planned merger with Columbia House has been terminated.

Already trading in the single digits, the announcement depressed shares further. They now trade for less than $7, a fraction of their 52-week high of $23.26. The shares were first sold to the public in February 1998 for $16 and topped $35 two months later.

CDNow is hardly the only e-tailer to fall out of favor with investors. Just as a rising tide once lifted all e-commerce companies, the opposite is now true.

Amazon.com has fallen about 30 percent since Dec. 1, a relatively modest decline considering the fate of some smaller competitors. Value America shares are down about 60 percent in the same time period; Beyond.com is off nearly 50 percent, while eToys has plunged almost 80 percent.

"The amount of competition right now is overwhelming," said Dan Ries, vice president of equity research at C.E. Unterberg Towbin.

CDNow sells music CDs, cassettes and DVDs online. With the merger, the company envisioned a huge push into the music sales business by combining its online sales with Columbia House's mail-order business.

The merger announced last July would have formed a new company jointly owned by CDNow, Time Warner and Sony, with CDNow owning 26 percent and Time Warner and Sony each receiving about 36 percent.

But investors never warmed to the idea, as CDNow shares fell more than 50 percent from the day the merger was announced to when it was terminated.

"They were looking for a way to promote the CDNow brand without having to pay the marketing costs that come with such an effort," said Rob Martin, senior Internet analyst at Friedman Billings Ramsey. Martin recently cut the stock to "accumulate" from "market perform."

Instead, Time Warner and Sony will invest $51 million into the company, with $21 million as an equity investment to buy 2.4 million shares. The remainder will be used to convert $30 million in short-term loans into long-term debt.

Martin said CDNow needs more investments to compete with other retail sites such as Amazon, which sold $78 million worth of music and $64 million of DVDs in the United States during its fourth quarter. CDNow, by comparison, generated $147 million in total sales during the entire fiscal year.

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CDNow "needs a substantial chunk of cash to get to the next level," said Martin. "I think they will continue to look for a buyer or someone who can invest about $150 million into the company."

CDNow chief executive Jason Olim agrees. The company is looking for a partner with "deep pockets" and resources to help it increase its marketing reach, he said.

In the meantime, the company will cut back its marketing and promotion programs, which should reduce revenue in the second quarter, Olim added.

Martin estimates that the company will record sales of between $25 million and $35 million for the quarter--substantially less than his previous estimate of $50 million.

"We want to reduce the total company cash expenditure by about one third going forward," said Olim. He also said the company aims to trim marketing expenses by about $10 million to $12 million each quarter. "Our goal is to get the company in a better financial position and reduce losses substantially, and we are willing to sacrifice some revenue to do that."

The company plans to cut inefficient marketing practices such as coupon programs, which "have a long pack-back period," according to Olim.

He said the company's affiliate program, in which Web sites post links to CDNow, has been more cost effective. Some of the larger affiliates include AltaVista, Yahoo and America Online.

Despite the turmoil, the company does have strengths that could appeal to a partner or acquirer.

PC Data reported that CDNow just surpassed Amazon in sales to unique buyers during the month of February. Martin said the company's 3.2 million customers are valuable, but adds that this customer base may shrink along with the marketing budget.

Meanwhile, CDNow will be working this year to improve its appeal to potential suitors.

As analyst Martin concluded in a recent report, "While we are aware of the vast opportunity of the $40 billion global music market, we are not confident that CDNow will remain a long-term leader. In our view, CDNow is merely biding time until a white knight appears to salvage the company from its current situation."

Olim would not comment specifically on the partner search but said, "We are actively seeking investors and are speaking to a number of parties."