Using the Peter Lynch metric,

CDnow

(CDNW)

is doing very nicely.

The music retail site topped

PC Data Online's

Top 20 Online Retailers list in February, with more than a million unique buyers. It has more than 3.2 million customers. Fourth-quarter sales more than doubled from a year earlier. It has an easy-to-remember name. So it's doing well, right?

Not exactly. This week it said its proposed merger with

Columbia House

fell apart and that it hired investment banker

Allen & Co.

to explore those ever-popular "strategic options." It will cut costs by one-third. On Wednesday, its stock fell for the fourth straight day, closing off 3/16, or 2.7%, at 6 25/32. And now the company must find a partner or be bought out, analysts say.

It's not that CDnow is a bad company. But it is selling a commodity product in a very competitive industry, while simultaneously spending heavily to promote its brand name. That makes its business model tough to actually pull off. And its fate illustrates how Internet retailers can simultaneously be good for consumers and bad for investors.

Tough Going

By all accounts, the $15 billion or so music-retailing business is a tough one. Bricks-and-mortar music retailers expanded wildly in the late 1980s and early 1990s as consumers swapped their LPs for CDs, then were stuck with a glut of stores when the market matured. Chains consolidated during the 1990s --

Trans World Entertainment

(TWMC) - Get Report

bought

Camelot

, while

Wherehouse

bought

Blockbuster Music

.

Wal-Mart

(WMT) - Get Report

and

Costco

(COST) - Get Report

sell CDs for cheap.

Online competition includes

Amazon.com

(AMZN) - Get Report

TheStreet Recommends

, as well as sites such as

Wal-Mart.com

and

BestBuy.com

. Price competition on top hits is the norm.

In the online world, "those who sell music, as well as other products, can probably do it profitably, but it's not clear that one who sells only music can do it profitably," says Ken Cassar, analyst with

Jupiter Communications

.

Amazon, for example, doesn't have to go out and spend huge piles of money to promote its CD sales; customers already used to coming to the site for books can be cheaply introduced to its music offerings. And because customers are already there, 1-Clicks enabled, they're less likely to stop and compare prices with other sites. But CDnow has to spend a lot to pull in customers on the appeal of CDs alone. (Even Amazon isn't profitable on anything except --

arguably -- its book business.)

And CDnow's numbers show how very hard it is to base a business on just one product category. In the fourth quarter, sales rose 154% to $53.1 million. Not bad. But music retailing, even on the Web, is not a high-margin business; gross profit totaled just 18% of sales during the quarter.

CDnow also spent nearly $26 million on sales and marketing during the quarter in order to pump up its brand. That's about 50% of sales. At times, that percentage has been even higher -- in the quarter that ended in September 1998, the company had sales of $13.9 million and sales and marketing expenses of $12.9 million. The company said it will focus more on low-cost marketing, like affiliate programs, in the coming quarter. That will reduce operating expenses and burn rate, but it also will reduce revenue and gross profits, the company said.

That financial picture does not exactly signal that profitability is on the horizon. Faced with price competition and tight margins, e-tailers like CDnow need to focus on adding additional revenue streams -- to figure out how else to wring money out of those 3.2 million customers with ads or other money-generators, says Rob Martin, an analyst with

Friedman Billings Ramsey

. (He cut CDnow's rating to market perform from accumulate following the merger's collapse, and his firm hasn't done recent underwriting for the company.) Or, it needs to find some other way besides advertising to bring people to the site, like linking with a content partner.

Christmas in July

To be sure, CDnow is not about to go out of business. According to its fourth-quarter earnings release, it had about $21 million in cash at the end of 1999. And Columbia House's owners,

Time Warner

(TWX)

and

Sony

(SNE) - Get Report

, said they'd ante up another $21 million in cash, and would convert a $30 million short-term loan commitment to long-term convertible debt. But long term, it needs a partner.

CDnow isn't the only retailer in a pickle. The whole sector has sucked wind lately, due to concerns over profitability, as well as a shift toward the new Internet It Girls, B2B stocks. But some companies that are particular favorites of consumers may have problems pleasing investors.

Buy.com

(BUYX)

practically gives stuff away.

Pets.com

(IPET)

also spends heavily on marketing (sock puppets don't come cheap) and to ship commodity products.

More.com

locks in prices on certain items for life. Consumers love them: Who doesn't like free shipping and 20-pound sacks of dog food delivered to the front door? But investors may not be so warm and fuzzy.

And what about CDnow's future? Well, in a statement, Allen & Co.'s Nancy Peretsman said her firm is "very optimistic about finding interest in attractive strategic transactions." A CDnow spokeswoman wouldn't comment further, but said she was "very confident we will have an operating plan that will allow us to continue."

"This company needs a strategic alliance or a partner or to be bought out," says one hopeful-sounding hedge fund manager who's long the stock. "It can't stand alone. I'm optimistic it will be bought."