CDnow's Planned Stock Offering May Hit a Sour Note with Investors

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CDnow

(CDNW)

isn't going to win any awards for timing.

Just as the online retailer's stock and a slew of others are coming down from Internet-related highs in April, CDnow may accelerate its slide by belting out a secondary offering.

After enjoying strong performance early in the year, CDnow has skidded along with some other Internet stocks. CDnow is down about 40% from a high of 39 last month to a close of 23 3/8 on Friday. The news of more shares coming to market is also coinciding with another troubling fact: The shares are getting awful close to their first trade price of 22. CDnow's IPO was priced at 16 in February.

Shareholders of the Jenkintown, Pa.-based Internet retailer of compact discs have lauded the company's plan to become to music what

Amazon.com

(AMZN) - Get Report

is to books. But cheers may diminish once the secondary offering comes into focus. The secondary will dilute the current public float about 60%.

In a May 11 filing with the

Securities and Exchange Commission

, CDnow said it plans to raise about $70 million by selling 2.5 million shares. The underwriters for the offering are

BT Alex. Brown

,

NationsBanc Montgomery

and

Hambrecht & Quist

. A member of BT's equity syndicate said the deal is likely to go out in early June, following a roadshow -- in case any investors have forgotten the company's story in the last 12 weeks.

"I don't know why they are doing this secondary now," says Paul Cook, portfolio manager for

Munder Capital's

Net Net

fund, which specializes in Internet stocks. (The fund currently doesn't hold any CDnow stock.) At a time when the stock is continuing to sputter, another output of shares could only exacerbate problems, Cook notes.

Even followers of the stock's fundamentals and story aren't completely sold on an offering at this time. "Rarely do you see a secondary offering on a stock down nearly 50% from its recent high," wrote one poster called "gsb99" in an Internet chat room devoted to the stock. "This is a clear indication that management still feels the stock is at a high -- otherwise they'd wait for the 30s to sell more shares."

Shareholders curious for answers won't find many in the company's prospectus on the deal. In the filing, CDnow admits it still has almost all the cash proceeds on hand from the IPO, about $60.5 million, as of March 31. The company also concedes it "has not designated any specific use for a significant portion" of either the existing cash or the proceeds from the proposed offering. The successful completion of the secondary offering could give the company about $130 million in idle cash reserves. (CDnow does plan to spend around $19 million for linking alliance agreements, $17 million for advertising and promotion, and $4.5 million for a Web site upgrade, according to the prospectus.)

Shorts Take Notice

Joel Sussman, CDnow's chief financial officer, defends the company's planned offering, saying the deal is weeks away and the stock price is likely to fluctuate prior to pricing. "You don't try to raise funds right when you need them," Sussman said, adding the secondary has been in the planning stages for a while.

The company is followed by only two analysts: Steven Horen at NationsBanc Montgomery, who declined comment, citing his firm's role in the secondary offering; and Christopher Feiss, at BT Alex. Brown, who did not return phone calls. Both have a buy recommendation on the stock.

CDnow is tightly controlled, with almost 70% inside ownership. The secondary offering will drop that to around 55%. At the conclusion of the offering, founding brothers

Jason and Matthew Olim

will each own a 16% stake; Alan Meltzer, a director, will own 11.2%; and

Grotech Partners

, a venture capital firm, will hold 12.5%, according to the filing. Following the offering, there will be around 18.5 million shares outstanding, with about 8.3 million, roughly 44%, in public hands.

None of the inside holders are selling shares in the secondary, although the restriction period on the IPO shares was lifted earlier this month. Indeed, according to the prospectus, some insiders have signed agreements that they will not sell their shares until some time after the secondary. In addition, the company filed a separate registration statement last month to cover up to another 1.6 million shares under an equity compensation plan for certain employees.

The fact that no insider is selling shares is "considered a positive," Sussman explained. "It shows a great confidence in the company." While that's true, a cynic could point out that while insiders have no problem issuing new shares at $23, they are reluctant to sell their own shares at that price.

CDnow sells music CDs via its

Web site

, and it regards itself as the leader in online music sales, boasting a catalog of 250,000 products, according to the filing. The company has sought name recognition through alliances with a number of well-known Net names, including

Yahoo!

(YHOO)

,

Excite

(XCIT)

and

Lycos

(LCOS)

.

However, the online music retail sector is about to become much more crowded. Amazon.com recently began adding CDs to its arsenal for online consumers, and

Borders Group

(BGP)

is looking to elbow into the sector, too. Both companies have deep experience in squeezing out the little guy.

The other companies usually named as CDnow's two closest rivals,

K-tel

(KTEL)

and

N2K

(NYKI)

, also are ticking down after the Internet-fueled run-up. Both retailers took the opportunity to increase liquidity at the height of the Internet run-up: K-tel elected to do a 2-for-1 stock split; N2K chose to do a secondary offering. N2K now is being sued by new shareholders who don't like the 30% nosedive the stock has taken since the offering.

In addition, short-sellers likely are loving CDnow's secondary offering and its potential to further hammer the stock. Short activity in CDnow has almost doubled in the last month, from around 177,150 shares at the end of March to almost 332,470 shares at the end of April -- roughly equivalent to about one day's worth of average trading volume.

Even though the company's sales revenue is increasing, losses are galloping ahead at an even faster rate. Last year, CDnow's net sales almost tripled, reaching $17.4 million, compared with $6.3 million for 1996. However, losses increased sixfold, to $10.7 million last year, up from $1.8 million in 1996.

For the first quarter, ended March 31, the company posted a net loss equal to almost all its red ink of last year, $9.2 million, or roughly a loss of 78 cents per share. For the first quarter of 1997, by comparison, the company lost $544,000, or 7 cents per share. Revenue continued to increase, however, reaching $10 million compared with $2.6 million for the first quarter of last year.

Still, if you are going to lose $9 in earnings for every $10 in sales, perhaps investors better hope CDnow doesn't become too popular. In the offering prospectus, the company cited its possible inability to manage potential growth and its cost-of-sales problem as two main risk factors in investing in the company.