Tech Industry

CDNow founders profit as investors take a beating

The brightly colored home page at CDNow.com belies the trouble at the corporation behind it--so much trouble that last month, the company announced it was selling itself to Bertelsmann.

There's a cheerful, information-packed home page with a picture of Ella Fitzgerald, hotlinks to a Stone Temple Pilots interview, and a concert search engine, as well as a music-shopping menu offering everything from rock to gospel to movie soundtracks. The CDNow Web site looks like the hottest thing in online shopping.

But the brightly colored home page at CDNow.com belies the trouble at the corporation behind it--so much trouble that late last month, CDNow announced it was selling itself to Bertelsmann, the giant German media company, for about $141 million in cash and assumed debt, in a deal expected to close this fall.

The sale came after the Ft. Washington, Pa., company had tallied losses of $212 million since 1994. Without the merger, CDNow would have run out of cash in September, it said. Now the company will become a wholly owned subsidiary of Bertelsmann. It will remain headquartered in Ft. Washington.

Only two years ago, things looked very different. When CDNow went public in February 1998, investors gobbled up shares at $16 apiece, and the stock soared to $35.50 in the next two months. But by the beginning of 2000, shares were down to around $10. At the start of August, they were trading at less than the $3 Bertelsmann will pay for them.

Investors who suffered big losses may be irked that the company's 31-year-old co-founders, brothers Jason and Matthew Olim, will get about $17.4 million for their 5.8 million shares, which represent about 17 percent of the shares outstanding. While those shares were once worth more than $200 million, the merger remains a handsome payday for the brothers, who acquired that stock for next to nothing when the company was founded in their parents' basement.

CDNow's 400 employees have found that most of their 3.5 million stock options--one of the chief attractions to work in the online world--are worthless.

What went wrong?
In a sense, it's not so much a question of what went wrong as what did not go right. Most online businesses are unprofitable. CDNow, despite its growing sales and success at staying in the spotlight--it was the third-most-visited music site, according to researchers at Media Metrix--has not been able to turn a profit in an industry where margins are tiny at best. It lost $14 million in the quarter ended June 30, despite adding 270,000 new customers.

Wall Street analysts note that e-commerce is a war of attrition likely to be won by the most heavily financed companies--those that can afford to operate at losses until their competitors wither. The two biggest online music players are merely Internet incarnations of companies that already are successful in the non-virtual world: Barnes & Noble and BMG Entertainment, owned by Bertelsmann.

CDNow has struggled to raise money to keep going until it could get in the black, finally searching in vain for a White Knight to rescue it. But an attempt to merge with Columbia House, the big music seller owned by Sony and Time Warner, fell apart in March. CDNow auditors reported at the time that there was "substantial doubt" the company could stay in business.

Wharton marketing professor Peter Fader, who has studied CDNow, says the company made the same mistakes as many other online retailers: failing to realize that success comes only to companies that get customers to return again and again. This rule is no different for online retailers than for old-fashioned brick-and-mortar stores, he says.

Many online businesses interpret rising numbers of site visits as a positive sign, even though only a tiny fraction of visitors make purchases. This focus is deceptive, Fader says. Any new business, online or off, experiences a honeymoon when visitors come out of curiosity. In fact, most never return. "People visit to see what's new, just to browse," he says.

Traditional retailers special report: Apart at the seamsare aware of this, while many online retailers are not. Yet the problem is especially acute for online businesses, as casual visits are so easy, Fader adds.

"If you look at the standard report card that the (online) industry uses, it is based primarily on the number of visitors and the amount of time they spend on the site." No grocery or department store would gauge success by foot traffic, but that's what online companies like CDNow tend to do, he says.

Traditional retailers gauge success on sales and profit figures, while online companies tend to play down such figures. Experience shows that online losses can continue for years, so Internet companies tend to avoid focusing on earnings. Instead, they often brag about the large percentage of recent customers who have made purchases before. Indeed, in its report on the quarter ended June 30, CDNow boasted that "approximately 72 percent of sales in the quarter came from repeat purchases by existing customers, as compared to 66 percent in the first quarter of 2000."

But this type of figure is a "meaningless statistic," Fader says, because it fails to account for past customers who made purchases but did not return. Indeed, Fader's study of CDNow found that most customers who made purchases early in 1997 gradually drifted away.

At many online retailers, the failure to create long-term customer loyalty is masked by statistics showing ever-greater numbers of people visiting the sites. But it can be extraordinarily expensive to mount the marketing campaign needed to lure new customers, while loyal, repeat customers come back on their own. Fader argues that e-companies that carefully study customer behavior will be better able to use limited marketing resources to the best effect.

Traditional retailers understand customer habits, and Fader therefore thinks online units of traditional companies have better prospects than standalone Internet companies. That may give CDNow a second chance. Not only is Bertelsmann a traditional company with deep pockets, but its BMG music operation, a kind of record-of-the-month club, has experience at evaluating customer behavior.

Still, Fader argues, there's no guarantee any of the online CD sellers will flourish. Music is becoming a commodity offering very small profits because of increasing competition from online and traditional offline merchants.

Lessons learned
What lessons can investors take from the CDNow tailspin? CDNow is just one among many money-losing Internet companies that became investment darlings in the past few years, only to come tumbling down. Buying a stock means buying the right to share in company profits, either now or in the future. Clearly, investors ignore a lack of earnings at their peril. Internet plays are highly speculative, as so few e-companies make money. Most speculators get burned.

Any investor who took the Special report: End of the Beginningtrouble to read CDNow's prospectus would have found a long list of "risk factors": that the company had experienced substantial losses, had little operating history, and faced fierce competition.

Moreover, the Olims and two other insiders owned controlling interest in the company. "As a result, such persons, acting together, will have the ability to control all matters submitted to shareholders of the Company for approval," the prospectus stated. Even if outside shareholders were unhappy with the company's performance, they had little chance of forcing a change in management.

 
To read more articles like this one, visit Knowledge@Wharton.

All materials copyright © 2000 of the Wharton School of the University of Pennsylvania.