September 23, 1999 4:00 PM PDT

Can CDNow merger hit top of the charts?

CDNow and Columbia House will be marching to the beat of a new chief executive once their proposed merger is completed. But it remains an open question whether CEO Scott Flanders can come up with the big hit needed to lift CDNow's stock out of a rut in the face of increased competition.

Over the past year, CDNow has watched its stock slide from a high of 39.25 as Amazon.com, Buy.com, Virgin Megastores, Barnesandnoble.com, and others invaded its online music retailing territory. The stock closed yesterday at 12.5.

Flanders was named yesterday to lead the planned integration of CDNow and Columbia House and will become chief executive of the new, yet-unnamed public company. CDNow's current chief, Jason Olim, will serve as CEO of the new company's online retail division, while Richard Wolter, chief of Columbia House, will head up club operations.

Flanders, the former president of computer and reference book publisher Macmillan Publishing, joined direct-marketing music and video club Columbia House after serving as chief executive and chairman since 1998 of wireless products and services firm Telstreet.com.

Although some analysts were surprised by the appointment of Flanders, whom they consider a relative unknown in the online business, some were quick to assert that his strength may lie in managing the new company's relationship with its corporate parents, media powerhouses Time Warner and Sony.

With the breadth of products controlled by the media companies, analysts agreed that CDNow could put up a strong battle against its encroaching competitors in a market that is expected to grow to $2.5 billion in 2003 from $374 million in 1998, according to Forrester Research.

Time Warner said Flanders was unavailable for comment because of a Securities and Exchange Commission-mandated "quiet period."

In July, CDNow entered into an agreement with Sony and Time Warner to merge with their jointly owned Columbia House. At the completion of the merger, Sony and Time Warner will each own 37 percent of the new public company, while existing CDNow shareholders will hold a 26 percent stake.

The merger with Columbia House is CDNow's second major merger since it went public in February 1998. In October 1998, CDNow agreed to merge with N2K's Music Boulevard in an attempt to reverse its falling stock following Amazon's entry into the online music market.

In the first six months of selling music online, Amazon nearly matched the total annual sales for CDNow last year. This year, analysts said they expect Amazon to grab the lead completely.

Powerful backers lend some weight
With media giants Sony and Time Warner watching CDNow's back, most analysts said they see a clear way for the Net retailer to differentiate itself from its competitors. Sony and Time Warner have vast catalogs of music, film, news, and other content to serve up, giving CDNow an opportunity to be strongly positioned for its transformation from strictly an e-commerce store to a music and film destination site.

Sony Music and Warner Music, divisions of Sony and Time Warner, respectively, are two of the "Big Five" record companies, along with BMG, EMI, and Universal Music. In addition, Sony operates movie studio Sony Pictures Entertainment and television firm Columbia TriStar, along with its electronics and games businesses. Time Warner also holds several entertainment interests including Warner Bros. television and movie studios, HBO, and the Turner Entertainment Networks.

"My gut reaction is that CDNow has the potential do as well as Sony and Time Warner let it do," said Malcolm Maclachlan, an analyst at International Data Corporation. "They control lots and lots of music content, and they could have all kinds of cross promotions."

CDNow's Olim said that although the company is generally thought of as an e-commerce company, it also raises revenue in other ways.

"We are the second-largest e-commerce company on the Web, but we are actually, as of now, one of the top 50 publishing sites in [advertising] revenues," Olim said, adding that the company generated about $2.5 million in ad revenues in the first and second quarter this year. "That was done with Microsoft, the Gap, and others paying to sponsor our site and editorial content."

Major recording companies are beginning to embrace online music downloading, reversing their earlier hesitation to do so. And today Sony will unveil the first Walkman supporting music downloaded from the Internet, marking the company's further commitment to the Net as a distribution channel.

"Right now [downloadable music] is more for promotion," said Olim. "My gut tells me that it will be awfully soon that we will start seeing significant sellable download products."

It is exactly these kinds of potential gold mines within its media giant parents that Flanders will have to exploit.

"[Flanders] strikes me as a manager who would be a steward," said Maclachlan. "[Time Warner and Sony] have all these different divisions that could relate to what CDNow does, but their motivations might not always match up."

Warner Music Group's chief executive Roger Ames yesterday in a statement promised Flanders the "full measure of Warner Music Group support."

Mail order: the 800-pound gorilla?
But some analysts see the company leveraging Columbia House's mail-order strengths in an effort to drive traffic to CDNow for an immediate boost to revenues.

Analyst Martin DeBono of Gomez Advisors said that CDNow must effectively draw Columbia House's nearly 16 million members to its site.

"If CDNow could get a 10 percent to 15 percent conversion rate, they could double their number of customers, which could double their revenues," said DeBono. Columbia House said it directly distributed approximately 200 million music and video units to its membership base last year.

"CDNow is one of the best sites on the Internet right now for music sales," said DeBono. "[Flanders's] job will be to let people who aren't shopping there, but who are Columbia House members, know about the site."

Olim said that one of the first items on Flanders's agenda will be to come up with a name for the merged company.

Analysts agreed that CDNow has somewhat outgrown its name given that consumers now look for not only CDs, but also DVDs, digital downloads, videos, and music and film news.

"Obviously we have two powerful name brands," said Olim. "And those are the brand names we want to leverage."

 

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