Bulked-Up CDnow Takes on Mighty Amazon

The merger between two music retailers could give Amazon.com a run for its music money.
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SAN FRANCISCO -- CDnow's (CDNW) merger with N2K, which joined a pair of online music also-rans, could have e-commerce behemoth Amazon.com (AMZN) - Get Report facing the music in the CD business.

If you'd asked just about any analyst six months ago who would be the biggest winner in online music, most would have said Amazon.com, even though Amazon entered that business just last summer. Analysts believed that Amazon's strong brand and its vast customer base would quickly propel the bookseller to the top of the charts.

CDnow and N2K, meanwhile, were struggling to build brand identity. Their stock prices were below 10. When the merger was announced, analysts saw it as a desperate move for survival.

Now the merged company, which is valued at more than $300 million, could well leverage experience, customers and money to build a strong brand that will give giant Amazon, valued at $24.1 billion, a run for its music money. CDnow closed Monday at 17 1/16.

"They can compete legitimately," says Jonathan Hanlon, a research analyst for

Fleet Investment Advisors

, which doesn't own any CDnow or Amazon shares. "As Web users get more sophisticated, they will go to niche stores" with strong brands.

If CDnow CEO Jason Olim has his say, his company will be the retailer of choice in its niche. A relaunch scheduled for May will provide more sound samples and content. And the merged company will spend less on advertising to build a single brand. "One plus one is more than two," Olim says.

The combined customer base will give CDnow more bargaining power with portals, says Kevin Wagner, an analyst at

Adams Harkness & Hill

. CDnow had about 983,000 customers, and N2K had about 720,000 customers, as of Dec. 31. Wagner rates CDnow accumulate and has no underwriting relationship with the company.

CDnow has an edge over Amazon in sales. CDnow's fourth-quarter sales, at $38.1 million on a pro-forma basis, beat Amazon.com's music sales of $33 million for the period. For 1998, the combined CDnow reported sales of $98.5 million. That's about half of the estimated $200 million in online music sales in 1998, according to

Forrester Research

. Amazon, which opened its music store midyear, showed about $47.5 million in music sales in 1998, out of $610 million in total revenue.

There are still many, especially some on the investment side, who are cautious about CDnow's chances of going up against Amazon. "Why get into a pushing war with a gorilla?" asks Ken McCain, a portfolio manager for

Wall Street Associates

, which sold its position in CDnow last year. "We sold because Amazon was coming, and they just have a better mind share. It's easy to go from books to music."

For its part, Amazon.com isn't shaking yet. The company is getting new customers every day who purchase music and videos from the site who have never bought books at Amazon, says Jennifer Cast, general manager of Amazon.com's music store. "We're building a better store ... and catching up quickly."

The landscape of the Internet has changed dramatically over the past few years, and behemoths can be born or killed in a matter of months. Right now, the top three music retailers are CDnow, Amazon.com and

Columbia House's

online store

TotalE

, according to Mark Hardie, a senior analyst at Forrester. But "by the time we get to 2001, the mix will be very different," Hardie says. He expects to see

Tower Records

,

Camelot Music

and

HMV

making aggressive moves onto the Internet by 2001; Forrester expects $4 billion in online music sales by 2002.

Right now, CDnow is offering a much better value, says Fleet's Hanlon. Amazon.com is trading at 36.5 times 1998 revenue of $610 million. CDnow is trading at 5.3 times combined 1998 revenue of $98.5 million.

Acquiring one of its biggest competitors was one of the ways CDnow plans to hold onto its top slot. "The idea that you must be a department store

on the Internet is wrong," says CDnow's Olim. The company is sticking with music, though it also plans to sell music books and music-related consumer electronics.