UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended : SEPTEMBER 30, 1998
------------------
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________________ to __________________
Commission File Number: 0-23753
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CDnow, Inc.
(Exact name of registrant as specified in its charter)
PENNSYLVANIA 23-2813867
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation of organization)
1005 VIRGINIA DRIVE, FORT WASHINGTON, PA 19034
(Address of principal executive offices and Zip Code)
(215) 619-9900
(Registrant's telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last
report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [X] NO [_]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Common Stock, No Par Value - 17,674,405 Shares Outstanding (October 22, 1998)
Page 1
CDnow, Inc.
INDEX
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Unaudited Consolidated Balance Sheets as of September 30, 1998 and
December 31, 1997.............................................................. 3
Unaudited Consolidated Statements of Operations for the three and nine months
ended September 30, 1998 and 1997.............................................. 4
Unaudited Consolidated Statements of Cash Flows for the nine months ended
September 30, 1998 and 1997.................................................... 5
Notes to Unaudited Consolidated Financial Statements........................... 6
ITEM 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations.................................................... 10
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings...................................................... 17
ITEM 2. Changes in Securities and Use of Proceeds.............................. 17
ITEM 3. Defaults Upon Senior Securities 18.................................... 18
ITEM 4. Submission of Matters to a Vote of Security Holders.................... 18
ITEM 5. Other Information...................................................... 18
ITEM 6. Exhibits and Report on Form 8-K........................................ 19
Signatures............................................................................ 20
Page 2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CDNOW, INC.
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
September 30, December 31,
1998 1997
------------------ ------------------
ASSETS
CURRENT ASSETS:
Current assets:
Cash and cash equivalents $ 59,563,026 $ 10,686,001
Short-term investments -- 1,003,045
Accounts receivable (net of reserves of $119,732 and $77,000) 811,175 324,411
Prepaid expenses and other 9,170,725 2,457,958
------------ ------------
Total current assets 69,544,926 14,471,415
PROPERTY AND EQUIPMENT, NET 4,129,299 1,884,296
OTHER ASSETS 3,897,161 92,714
------------ ------------
$ 77,571,386 $ 16,448,425
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Notes payable $ -- $ 5,575,288
Current portion of long term debt 635,160 361,562
Accounts payable 9,324,304 8,981,430
Accrued expenses 2,821,178 579,413
Other current liabilities 100,295 191,727
------------ ------------
Total current liabilities 12,880,937 15,689,420
------------ ------------
LONG TERM DEBT 1,130,484 962,144
DEFERRED RENT LIABILITY 160,990 56,717
REDEEMABLE SERIES A AND B CONVERTIBLE
PREFERRED STOCK -- 9,492,594
------------ ------------
COMMITMENTS AND CONTINGENCIES (Note 4)
SHAREHOLDERS' EQUITY (DEFICIT):
Preferred stock, no par value, 20,000,000 shares authorized, 254,582
Redeemable Series A Convertible and 1,605,505 Redeemable Series B
Convertible shares issued and outstanding at December 31, 1997
Common Stock, no par value, 50,000,000 shares authorized 17,674,336 and 101,482,736 579,549
7,845,684 shares issued and outstanding
Common stock, no par value 101,482,736 579,549
Additional paid-in capital 4,325,817 1,325,817
Deferred compensation (246,679) (434,776)
Accumulated deficit (42,162,899) (11,223,040)
------------ ------------
Total shareholders' equity (deficit) 63,398,975 (9,752,450)
------------ ------------
$ 77,571,386 $ 16,448,425
============ ============
The accompanying notes are an integral part of these statements.
Page 3
CDNOW, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
Three Months Ended Nine Months Ended
September 30, September 30,
1998 1997 1998 1997
------------------ ------------------ ------------------ ----------------
NET SALES $ 13,879,775 $ 3,906,661 $ 35,503,805 $ 9,452,864
COST OF SALES 10,980,974 3,059,849 28,549,562 7,333,069
------------ ----------- ------------ -----------
Gross profit 2,898,801 846,812 6,954,243 2,119,795
------------ ----------- ------------ -----------
OPERATING EXPENSES:
Operating and development 2,390,004 631,727 5,155,718 1,444,011
Sales and marketing 12,938,039 2,341,655 31,293,668 3,603,238
General and administrative 1,047,175 522,911 2,781,334 1,266,296
------------ ----------- ------------ -----------
16,375,218 3,496,293 39,230,720 6,313,545
------------ ----------- ------------ -----------
Operating Loss (13,476,417) (2,649,481) (32,276,477) (4,193,750)
INTEREST INCOME (787,183) (92,655) (2,015,234) (94,045)
INTEREST EXPENSE 68,160 23,156 563,074 29,961
------------ ----------- ------------ -----------
NET LOSS (12,757,394) (2,579,982) (30,824,317) (4,129,666)
ACCRETION OF PREFERRED STOCK TO REDEMPTION VALUE
------------ ----------- ------------ -----------
REDEMPTION VALUE................................. -- (263,748) (115,542) (263,748)
------------ ----------- ------------ -----------
Net Loss Applicable to Common Shareholders $(12,757,394) $(2,843,730) $(30,939,859) $(4,393,414)
============ =========== ============ ===========
Net Loss Per Common Share $(0.74) $(0.36) $(2.10) $(0.56)
============ =========== ============ ===========
Weighted Average Number of Common Shares 17,141,221 7,845,684 14,764,870 7,845,684
Outstanding ============ =========== ============ ===========
The accompanying notes are an integral part of these statements.
Page 4
CDNOW, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Nine Months Ended
September 30,
1998 1997
------------------ -----------------
OPERATING ACTIVITIES:
Net loss $(30,824,317) $(4,129,666)
Adjustments to reconcile net loss to net cash used in operating activities--
Depreciation and amortization 1,566,344 438,503
Provision for returns and doubtful accounts 121,732 5,000
Increase in operating assets and liabilities--
Accounts receivable (603,416) (54,875)
Prepaid expenses and other (4,966,500) (490,824)
Accounts payable 264,972 3,194,675
Accrued expenses 2,241,765 254,117
Deferred revenue (88,171) 44,602
Deferred rent liability 104,273 --
------------ -----------
Net cash used in operating activities (32,183,318) (738,468)
------------ -----------
INVESTING ACTIVITIES:
Sales and maturities of short-term investments 1,003,045 245,641
Purchases of short-term investments -- (983,600)
Purchases of property and equipment (2,320,232) (1,287,956)
Acquisition of a business (423,694) --
------------ -----------
Net cash used in investing activities (1,740,881) (2,025,915)
------------ -----------
FINANCING ACTIVITIES:
Borrowings on term loans payable 4,871 218,563
Payments on term loans payable (47,433) (14,546)
Payments on notes payable -- (200,000)
Repayment of Series A Notes and warrants (5,777,500) --
Proceeds from sale of Preferred stock -- 9,252,491
Repayment of advances due to related parties (3,261) --
Payments on capitalized lease obligations (296,325) (29,744)
Proceeds from warrants exercised 59,890 --
Proceeds from options exercised 128,820 --
Proceeds from issuance of Common stock, net 88,732,162 --
------------ -----------
Net cash provided by financing activities 82,801,224 9,226,764
------------ -----------
INCREASE IN CASH AND CASH EQUIVALENTS 48,877,025 6,462,381
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 10,686,001 775,865
------------ -----------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 59,563,026 $ 7,238,246
============ ===========
The accompanying notes are an integral part of these statements
Page 5
CDNOW, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1 -- BASIS OF PRESENTATION
The consolidated financial statements of CDnow, Inc. and its subsidiaries
(collectively, the "Company") included herein are unaudited and reflect all
adjustments (consisting only of normal recurring adjustments) which are, in the
opinion of management, necessary for a fair presentation of the financial
position and operating results for the three and nine month periods ended
September 30, 1997 and 1998.
The interim operating results of the Company may not be indicative of
operating results for the full year.
NOTE 2 -- THE COMPANY
The Company is an online retailer of compact discs ("CDs") and other music-
related products. The Company's revenues are almost entirely derived from the
sale of pre-recorded music and music-related products. The Company contracts
with outside vendors for fulfillment services to deliver its products to
customers. Therefore, the Company maintains no inventories.
Since inception (February 12, 1994), the Company has incurred significant
losses, and as of September 30, 1998 had accumulated losses of $43.6 million.
For the year ended December 31, 1997, and the nine months ended September 30,
1998, the Company's net losses were $10.7 million and $30.8 million,
respectively. The Company intends to continue investing heavily in marketing and
promotion, strategic alliances, Web site development and technology, and
development of its administrative organization. As a result, the Company
believes that it will continue to incur substantial operating losses for the
foreseeable future. Because the Company has relatively low product gross
margins, achieving profitability given planned spending levels depends upon the
Company's ability to generate and sustain substantially increased revenue and
gross margins. There can be no assurance that the Company will be able to
generate sufficient revenues or gross margins to achieve or sustain
profitability in the future.
NOTE 3 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation. The consolidated financial statements include the
accounts of CDnow, Inc. and its wholly owned subsidiaries. All intercompany
balances and transactions have been eliminated in consolidation.
Management's Use of Estimates. The preparation of financial statements in
conformity with generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
Net Loss Per Common Share. The Company has presented net loss per share amounts
for the three and nine month periods ended September 30, 1997 and 1998 pursuant
to Statement of Financial Accounting Standards ("SFAS") No. 128 "Earnings per
Share" and the Securities and Exchange Commission Staff Accounting Bulletin No.
98.
Basic loss per share was computed by dividing net loss applicable to common
shareholders by the weighted average number of shares of Common stock
outstanding during the three and nine months ended September 30, 1997 and 1998.
Diluted loss per share has not been presented, since the impact on loss per
share using the treasury stock method is anti-dilutive due to the Company's
losses.
Page 6
Cash and Cash Equivalents. For the purposes of the consolidated statements of
cash flows, the Company considers investment instruments with an original
maturity of three months or less to be cash equivalents. Cash equivalents are
comprised of investments in money market funds, government mortgage backed bonds
and highly rated corporate securities.
Revenue Recognition. Net sales, which consist primarily of recorded music sold
via the Internet, include outbound shipping and handling charges and are
recognized when the products are shipped. The Company records a reserve for
estimated returns, which is based on historical return rates.
Operating and Development Expenses. Operating and development expenses consist
principally of payroll and related expenses for store management, development,
editorial, and network operations personnel and consultants and expenses for
systems and telecommunications infrastructure, and royalties paid by the company
in return for licensing of ratings, revenues, sound samples and other
information.
Advertising Expense. Advertising costs are included in sales and marketing
expenses and are charged to expense as incurred. Such costs were $2,136,187 and
$23,695,757 for the nine months ended September 30, 1997 and 1998, respectively.
The Company gives merchandise credit to the providers of various small Web sites
through its Cosmic Credit Program. Expenses related to this program are included
in sales and marketing expenses. The Company estimates the amount of unused
credits and includes this amount in accrued expenses.
Public Offerings. On February 13, 1998 the Company consummated an initial
public offering of its Common Stock (the "Initial Public Offering"). The Company
sold 4,561,250 shares (including 461,250 shares upon the exercise of the
underwriters' overallotment option on March 4, 1998) of its common stock, no par
value, at an initial public offering price of $16.00 per share. After deducting
the underwriters' discount and other offering expenses, the net proceeds to the
company were $67,077,862.
On July 28, 1998 the Company consummated a second public offering of its
Common Stock (the "Secondary Offering"). The Company sold 1,250,000 shares of
its common stock, no par value, at a public offering price of $18.50 per share.
After deducting the underwriters' discount and other offering expenses, the net
proceeds to the company were $21,654,300.
Comprehensive Income. In June 1997, the FASB issued SFAS No. 130, "Reporting
Comprehensive Income" ("SFAS 130"). This statement requires companies to
classify items of other comprehensive income by their nature in a financial
statement and display the accumulated balance of other comprehensive income
separately from retained earnings and additional paid-in capital in the equity
section of a statement of financial position. The Company has adopted SFAS 130
in 1998. There are no other comprehensive income items for the nine months
ended September 30, 1997 and 1998, and accordingly this adoption has no impact
on the financial results of the Company for the three and nine month periods
ended September 30, 1997 and 1998.
NOTE 4 -- COMMITMENTS AND CONTINGENCIES
Yahoo! Agreement. On September 2, 1998, the Company entered into a global
merchant agreement with Yahoo! Inc. (the "Yahoo! Agreement"), extending and
expanding upon earlier agreements with Yahoo! of August 1997 and March 1998.
Under the Yahoo! Agreement: (i) the Company continues to be granted music-retail
exclusivity on music-related search-results pages on Yahoo!'s main directory,
www.yahoo.com, (ii) is integrated into other areas of the Yahoo! Service,
including Yahoo! Mail and (iii) becomes the premier music retailer on many of
Yahoo!'s international sites. The term of the Yahoo! Agreement ends on
December 31, 2000, except for presence on the international sites, which ends in
March, 2000. The Company may terminate the Yahoo! Agreement earlier upon
payment of a specified termination fee. Coincident with the Yahoo! Agreement,
Yahoo! agreed to purchase up to $2 million in newly-issued common shares of the
Company, of which $1 million was invested in September 1998, and the remainder
is to be invested as of December 31, 1999.
Excite Agreement. On September 30, 1997, the Company entered into a two-year
agreement with Excite, Inc. (the "Excite Agreement"), pursuant to which the
Company became the exclusive retail music store sponsor of the
Page 7
Webcrawler.com Web site. The Excite Agreement requires the Company to pay Excite
a set-up fee, an annual exclusivity fee and an annual sponsorship fee for
ongoing programming, links, placements, advertisements and promotions. The
Excite Agreement will expire in January 2000.
Lycos Agreement. On March 26, 1998, the Company entered into an agreement with
Lycos, Inc. (the "Lycos Agreement"), pursuant to which the Company became the
exclusive retail music store sponsor of the www.lycos.com and www.tripod.com Web
sites. The Lycos Agreement has a term of three years and will expire in August
2001. The Company has issued 82,224 shares (the "Lycos Shares") of common stock
to Lycos. The Lycos Shares vest as Lycos delivers certain required minimum page
views, as defined in the Lycos Agreement. The Company has the right to
repurchase any of the Lycos shares that do not become vested at a price of $0.01
per share. The Company will measure the stock granted as it vests. If Lycos is
unable to deliver a number of guaranteed minimum impressions, some of the Lycos
shares may not vest.
Lycos Bertelsmann Agreement. On April 2, 1998, the Company entered into an
agreement with Lycos Bertelsmann GMBH & Co. KG (the "Lycos Bertelsmann
Agreement"), pursuant to which the Company became the exclusive music retailer
on certain Lycos Bertelsmann branded Web services in Europe, as defined in the
Lycos Bertelsmann Agreement. The Lycos Bertelsmann Agreement has a three year
term expiring in April 2001.
MTV Agreement. On May 18, 1998, the Company entered into a binding memorandum
of terms for a three year advertising and promotion agreement with MTV Networks,
a subsidiary of Viacom International, Inc., pursuant to which the Company
committed to purchase advertising on the MTV and VH1 cable television channels
and obtained the right to use certain MTV and VH1 content. The Company has
granted MTV Networks a warrant to purchase 226,892 shares of the Company's
common stock at an exercise price of $23.28 per share. The warrant will vest
annually over the three years of the contract term.
Other Agreements. On January 5, 1998 the Company entered into a strategic
alliance with GeoCities pursuant to which the Company has been designated as the
exclusive music retailer as well as one of four key commerce partners that
occupy a premier position on certain pages of the GeoCities Web site. The
Company also has committed to make payments under advertising and linking
agreements with Rolling Stone Network, America Online with respect to the
Love@AOL service, and with certain other parties.
Payments Under Marketing Agreements and Strategic Alliances. The Company is
required to pay aggregate minimum fixed fees of $9.3 million, $27.4 million,
$26.7 million and $3.6 million during the remaining three months of 1998 and the
years ending December 31, 1999, 2000 and 2001, respectively, under the Company's
marketing agreements and strategic alliances.
The Company expects to amortize the costs associated with its marketing
agreements and strategic alliances over the contract terms, with the
amortization method primarily based on the rate of delivery of a guaranteed
number of impressions to be received during the contract term.
General. Many of the Company's agreements, including the Yahoo!, Excite, Lycos
and Lycos Bertelsmann Agreements, contain provisions which may require
additional payments to be made by the Company based on factors such as click-
throughs and new customers generated. To date, the amount of such payments has
not been material. Such payments are expensed as incurred. The Company will
continue to evaluate the realizability of assets recorded, if any, related to
the Yahoo!, Excite, Lycos, Lycos Bertelsmann and other agreements, and, if
necessary, write down the assets to realizable value.
NOTE 5 -- SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS
- ----------------------------------------------------
From time-to-time, the Company may publish statements which are not of
historical fact, but are forward-looking statements relating to such matters as
anticipated financial performance, business prospects, technological
developments, new products, research and development activities and similar
matters. The Private Securities Litigation Reform Act of 1995 provides a safe
harbor for forward-looking statements.
Page 8
These forward-looking statements are subject to certain risks and
uncertainties that could cause actual results to differ materially from
historical and anticipated results or other expectations expressed in the
Company's forward-looking statements. Such forward-looking statements may be
identified by the use of certain forward-looking terminology, such as "may,"
will," "expect," "anticipate", "intend," "estimate," "believe," "goal," or
"continue" or comparable terminology that involves risks or uncertainties.
Actual future results and trends may differ materially from historical and
anticipated results. This may occur as a result of a variety of factors,
including, but not limited to those set forth under "Overview" and "Liquidity
and Capital Resources" included in Management's Discussion and Analysis of
Financial Condition and Results of Operations section of this document and in
the "Risk Factors" section of the Company's prospectus which is part of the
Company's Registration Statement on Form S-1 (File No. 333-52367), as amended,
as filed with the Securities and Exchange Commission ("SEC"). Particular
attention should be paid to the cautionary statements involving the Company's
limited operating history, the unpredictability of its future revenues, the
unpredictable and evolving nature of its key markets, the intensely competitive
online commerce and entertainment environments, the Company's dependence on its
strategic alliances and key suppliers and distributors, and the risks associated
with capacity constraints, systems development, relationships with artists, and
the management of growth. Except as required by law, the Company undertakes no
obligation to update any forward-looking statement, whether as a result of new
information, future events or otherwise. Readers, however, should carefully
review the factors set forth in other reports or documents that the Company
files from time-to-time with the SEC and matters generally affecting online
commerce and online music retailing.
NOTE 6 -- SUBSEQUENT EVENT
On October 22, 1998, CDnow and N2K Inc., a Delaware corporation ("N2K"),
entered into an Agreement and Plan of Merger (the "Merger Agreement"). The
parties will create a new public company to be initially named CDnow/N2K, Inc.
("CDnow/N2K"). The Merger Agreement provides for the merger (the "Merger") of
wholly-owned subsidiaries of CDnow/N2K into each of CDnow and N2K. CDnow and
N2K will each survive the Merger and become wholly-owned subsidiaries of
CDnow/N2K. In the Merger, each outstanding share of common stock of CDnow will
be converted into one share of CDnow/N2K and each outstanding share of common
stock of N2K will be converted into .83 shares of CDnow/N2K. There is no collar
on the exchange ratio. As a result, the shareholders of CDnow would own
approximately 60% of the combined company and the stockholders of N2K would own
approximately 40% of the combined company. The closing stock prices on October
22, 1998, were $9.4375 for CDnow and $5.50 for N2K. The consummation of the
Merger is subject to many conditions and no assurance can be given that the
Merger will be consummated. A copy of the Merger Agreement is attached in
Exhibit 2.1 to the Company's Form 8-K filed on October 28, 1998.
Page 9
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
This Management's Discussion and Analysis of Financial Condition and Results
of Operations and other sections of this Quarterly Report contain forward-
looking statements within the meaning of the Private Securities Litigation
Reform Act of 1995. These statements address, among other things, the Company's
business strategy, including its sales and marketing plans; expectation of
future losses; competitive factors; reliance on online and traditional
advertising and strategic alliances; use of cash and cash equivalents; reliance
on certain vendors; projected capital expenditures; liquidity; Year 2000
disclosure, including statements regarding readiness, remediation, consequences
and contingency plans; increased sales in future periods; sales to international
customers; the continuation of fluctuations in results of operations, as well as
information contained elsewhere in this Report where statements are preceded by,
followed by or include the words "believes," "expects," "anticipates," "plans"
or similar expressions. These statements are based on a number of assumptions
concerning future events, and are subject to a number of uncertainties and other
factors, many of which are outside the Company's control, that could cause
actual results to differ materially from such statements. The Company
undertakes no obligation to update or revise forward-looking statements, whether
as a result of new information, future events or otherwise.
RECENT DEVELOPMENTS
Proposed Merger with N2K Inc. On October 22, 1998, CDnow and N2K Inc., a
Delaware corporation ("N2K"), entered into an Agreement and Plan of Merger (the
"Merger Agreement"). The parties will create a new public company to be
initially named CDnow/N2K, Inc. ("CDnow/N2K"). The Merger Agreement provides
for the merger (the "Merger") of wholly-owned subsidiaries of CDnow/N2K into
each of CDnow and N2K. CDnow and N2K will each survive the Merger and become
wholly-owned subsidiaries of CDnow/N2K. In the Merger, each outstanding share
of common stock of CDnow will be converted into one share of CDnow/N2K and each
outstanding share of common stock of N2K will be converted into .83 shares of
CDnow/N2K. There is no collar on the exchange ratio. As a result, the
shareholders of CDnow would own approximately 60% of the combined company and
the stockholders of N2K would own approximately 40% of the combined company.
The closing stock prices on October 22, 1998, were $9.4375 for CDnow and $5.50
for N2K. The consummation of the Merger is subject to many conditions and no
assurance can be given that the Merger will be consummated. A copy of the
Merger Agreement is attached in Exhibit 2.1 to the Company's Form 8-K filed on
October 28, 1998.
OVERVIEW
CDnow is a leading online retailer of CDs and other music-related products.
Its early entrance into the online music retailing industry has helped the
Company gain a well-recognized brand and a large customer base. The Company
strives to combine the advantages of online commerce with superior customer
focus in order to be the authoritative source for CDs and other music-related
products. CDnow's online store, cdnow.com, offers broad selection, informative
content, easy-to-use navigation and search capabilities, a high level of
customer service, competitive pricing and personalized merchandising and
recommendations. Due to the Company's dedicated retail focus, revenues are
almost entirely derived from the sale of pre-recorded music and related
products, drawing from its comprehensive selection of over 300,000 items.
CDnow has grown rapidly since its inception in 1994. Of the 738,000 customers
who have made purchases since inception through September 30, 1998, 442,000 made
their initial purchases during the nine month period ended September 30, 1998.
Average daily visits to the CDnow store have grown from approximately 12,000 in
January 1996 to approximately 215,000 in September 1998. The Company's net
sales grew to $13.9 million in the third quarter of 1998 compared to $11.6
million and $3.9 million in the second quarter of 1998 and the third quarter of
1997, respectively. The Company has also generated significant customer
loyalty. Despite the Company's rapid acquisition of new customers, repeat
customers accounted for approximately 59% of net sales in the third quarter of
1998.
The Company believes that the key factors affecting its long-term financial
success include its ability to obtain new customers at reasonable costs, retain
customers and encourage repeat purchases. The Company seeks to
Page 10
expand its customer base through multiple marketing channels, which include (i)
pursuing an aggressive marketing campaign using a combination of online and
traditional marketing, (ii) establishing strategic alliances with major Internet
content and service providers, (iii) entering into linking arrangements with
other Web sites as part of its Cosmic Credit Program and (iv) using direct
marketing techniques to target new and existing customers with personalized
communications. The Company entered into marketing agreements and strategic
alliances with Yahoo!, Excite and GeoCities in August 1997, September 1997 and
January 1998, respectively, and has accelerated its marketing campaign since the
Company's initial public offering in February 1998 by expanding its relationship
with Yahoo! and entering into additional alliances with Lycos, Lycos
Bertelsmann, Rolling Stone Network and MTV/VH1.
Since its inception, the Company has incurred significant net losses and, as
of September 30, 1998, had accumulated losses of $43.6 million. As it seeks to
expand aggressively, the Company believes that its operating expenses will
significantly increase as a result of the financial commitments related to the
development of marketing channels, future strategic relationships, and
improvements to its Web site and other capital expenditures. The Company
expects that it will continue to incur losses and generate negative cash flow
from operations for the foreseeable future as it continues to develop its
business. Since the Company has relatively low product gross margins, the
ability of the Company to generate and enhance profitability depends upon its
ability to substantially increase its net sales. To the extent that
significantly higher net sales do not result from the Company's marketing
efforts, the Company will be materially adversely affected. There can be no
assurance that the Company will be able to generate sufficient revenues from the
sale of CDs and other music-related products to achieve or maintain
profitability on a quarterly or annual basis.
For the quarter ended September 30, 1998 and the year ended December 31, 1997,
international sales accounted for approximately 22% and 29%, respectively, of
net sales. While the Company expects that net sales from international markets
will continue to represent a significant portion of total net sales, the Company
believes that the percentage of its net sales from international markets may
decrease in future periods due to the substantial increase in the Company's
domestic marketing and advertising expenditures.
Page 11
RESULTS OF OPERATIONS
The following table sets forth statement of operations data as a percentage of
net sales for the periods indicated:
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------- -------------
1998 1997 1998 1997
------------- ------------- ------------- -------------
Net Sales 100.0% 100.0% 100.0% 100.0%
Cost of sales........................................................ 79.1 78.3 80.4 77.6
------ ------ ------ ------
Gross profit....................................................... 20.9 21.7 19.6 22.4
Operating Expenses:
Operating and development.......................................... 17.2 16.1 14.6 15.3
Sales and marketing................................................ 93.2 60.0 88.1 38.1
General and administrative......................................... 7.6 13.4 7.8 13.4
------ ------ ------ ------
Total operating expense............................................ 118.0 89.5 110.5 66.8
------ ------ ------ ------
Operating loss..................................................... (97.1) (67.8) (90.9) (44.4)
Interest income (expense), net....................................... 5.2 1.8 4.1 0.7
------ ------ ------ ------
Net loss............................................................. (91.9)% (66.0)% (86.8)% (43.7)%
====== ====== ====== ======
Beginning in 1998, the Company determined to include royalties paid on CD
sales in return for licensing of ratings, reviews and other information
("Information Royalties") in operating and development expenses rather than in
cost of sales, as was previously the case. This change was made based on
management's determination that including Information Royalties in operating and
development expense was more consistent with the treatment of such expenses by
retailers generally. The financial information in this Form 10-Q related to the
Company's results of operations for periods prior to 1998 has been restated to
reflect this change. Information Royalties were $54,000, $151,027, $131,922 and
$269,041, respectively, during the three and nine months ended September 30,
1997 and the three and nine months ended September 30, 1998, respectively. If
Information Royalties were included in cost of sales, gross profit margins would
have been 20.3%, 20.8%, 19.9% and 18.8% during the three and nine months ended
September 30, 1997 and the three and nine months ended September 30, 1998,
respectively.
During the quarter ended September 30, 1998, the Company determined to include
credit card processing fees ("Credit Card Fees") in sales and marketing expenses
rather than in cost of sales, as was previously the case. This change was made
based on management's determination that including Credit Card Fees in sales and
marketing expense was more consistent with the treatment of such expenses by
retailers generally. The financial information in this Form 10-Q related to the
Company's results of operations for periods prior to the quarter ended September
30, 1998 has been restated to reflect this change. Credit Card Fees were
$107,256, $246,879, $366,979 and $952,991, respectively, during the three and
nine months ended September 30, 1997 and the three and nine months ended
September 30, 1998, respectively. If Credit Card Fees were included in cost of
sales, gross profit margins would have been 18.9%, 19.8%, 18.2% and 16.9% during
the three and nine months ended September 30, 1997 and the three and nine months
ended September 30, 1998, respectively.
Net Sales. Net sales primarily reflect the sales of CDs and related
merchandise, net of estimated returns, and include outbound shipping and
handling charges. Net sales were $13.9 million and $35.5 million for the three
Page 12
and nine months ended September 30, 1998, respectively, representing increases
of 255% and 276% over the corresponding periods in 1997. The increase is
attributable to continued growth of the Company's customer base and repeat
purchases from existing customers. Net sales were favorably affected by
increased advertising and promotional activities, including the Company's
purchase of advertising during the 1998 Grammy Awards and MTV Video Music
Awards, as well as the continued implementation of its strategic alliances. For
the three and nine months ended September 30, 1998, the Company added
approximately 159,000 and 442,000 new customers, bringing the total number of
customers since inception to 738,000 as of September 30, 1998 from 296,000 at
December 31, 1997. International sales represented 22% of net sales for each of
the three and nine months ended September 30, 1998 compared to 31% and 33% for
the corresponding periods in 1997. The Company believes that the decrease in
international sales as a percentage of net sales is due to a proportionally
larger increase in domestic sales resulting from the substantial increase in
domestic marketing and advertising expenditures. Nevertheless, international
sales increased to $2.9 million and $7.6 million for the three and nine months
ended September 30, 1998, respectively, from $1.3 million and $3.2 million in
the corresponding periods of 1997.
Cost of Sales. Cost of sales consists primarily of the cost of merchandise sold
to customers, including product fulfillment and outbound shipping and handling.
Cost of sales were $11.0 million and $28.5 million for the three and nine months
ended September 30, 1998, respectively, compared to $3.1 million and $7.3
million for the corresponding periods in 1997. The Company's gross profit margin
decreased to 20.9% and 19.6% for the three and nine months ended September 30,
1998, respectively, compared to 21.7% and 22.4% for the corresponding periods in
1997. The decline in gross margin was attributable to more aggressive pricing
of recent releases and popular titles, as well as increased sales discounts
offered by the Company. Gross margin for the three months ended September 30,
1998 was 20.9% compared to 20.0% for the three months ended June 30, 1998; this
increase was attributable to selective price increases implemented late in the
second quarter and an increase in revenues from advertising which has a higher
margin than product sales.
Operating and Development Expense. Operating and development expense consists
primarily of payroll and related expenses for store management, design,
development and network operations personnel, systems and telecommunications
infrastructure, and royalties paid by the Company on CD sales in return for
licensing of ratings, reviews, sound samples and other information. Store
development costs are charged to expense as incurred. Operating and development
expenses were $2.4 million and $5.2 million, respectively, for the three and
nine months ended September 30, 1998 compared to $632,000 and $1.4 million for
the corresponding periods in 1997. The increase is attributable to increased
staffing and associated costs related to enhancing the features and
functionality of the Company's Web site and transaction-processing systems, as
well as increased investment in store content, systems and telecommunications
infrastructure. As a percentage of net sales, operating and development expense
were 17.2% and 14.6% for the three and nine months ended September 30, 1998,
respectively, compared to 16.1% and 15.3% for the three and nine months ended
September 30, 1997.
Sales and Marketing Expense. Sales and marketing expense consists primarily of
payments related to advertising, promotion and strategic alliances as well as
payroll and related expenses for personnel engaged in marketing, selling and
customer service activities. Sales and marketing expenses were $12.9 million and
$31.3 million for the three and nine months ended September 30, 1998,
respectively, compared to $2.3 million and $3.6 million for the three and nine
months ended September 30, 1997. As a percentage of net sales, sales and
marketing expense grew to 93.2% and 88.1% for the three and nine months ended
September 30, 1998, respectively, compared to 60.0% and 38.1% for the three and
nine months ended September 30, 1997. The increase in both absolute dollars and
as a percentage of net sales was primarily attributable to increased online and
traditional advertising, including the Company's purchase of advertising during
the Grammy Awards and the MTV Video Music Awards, costs associated with the
Company's strategic alliances and promotional and public relations expenditures.
The Company increased its advertising expense to $9.7 million and $23.7 million
for the three and nine months ended September 30, 1998, respectively, compared
to $1.6 million and $2.1 million for the three and nine months ended September
30, 1997. In addition, the Company incurred increased staffing and related
costs in connection with the implementation of its marketing strategy and
customer service activities necessary to support its increased customer base,
and increased credit card processing fees related to the growth of revenues.
The Company expects the dollar amount of sales and marketing expense generally,
and advertising expense in particular, to continue to increase in future
periods. While the Company is hopeful that its net sales will also increase in
future periods so that its sales
Page 13
and marketing expense will not continue to represent an increasing percentage of
net sales, the Company is not able to predict whether its net sales will
increase by a sufficient amount for this to occur. No assurance can be given
that the Company will achieve increased net sales or that sales and marketing
expense will not increase as a percentage of net sales.
General and Administrative Expense. General and administrative expense consists
of payroll and related expenses for executive, accounting and administrative
personnel, insurance, professional fees and other general and corporate
expenses. General and administrative expenses were $1.0 million and $2.8
million for the three and nine months ended September 30, 1998, respectively,
compared to $523,000 and $1.3 million for the three and nine months ended
September 30, 1997. The increase in general and administrative expense was
primarily due to the hiring of additional personnel and increases in
professional fees, as well as the costs associated with becoming a public
company. As a percentage of net sales, general and administrative expense
decreased to 7.6% and 7.8% for the three and nine months ended September 30,
1998, respectively, from 13.4% and 13.4% for the three and nine months ended
September 30, 1997, respectively, as the Company's fixed costs were spread over
a larger revenue base.
Net Loss. The Company's net loss was $12.8 and $30.8 million for the three and
nine months ended September 30, 1998, respectively, compared to $2.6 million and
$4.1 million for the three and nine months ended September 30, 1997.
LIQUIDITY AND CAPITAL RESOURCES
At September 30, 1998 the Company's cash and cash equivalents were $59.6
million compared to $7.2 million at September 30, 1997. In July 1998, the
Company consummated a follow-on public offering, selling an aggregate of
1,250,000 shares of Common Stock and raising net proceeds of approximately $21.7
million. In February 1998, the Company consummated its initial public offering,
selling an aggregate of 4,561,250 shares (including 461,250 shares sold in March
1998 upon the exercise of the underwriters' overallotment option) of Common
Stock and raising net proceeds of approximately $67.0 million. Prior to
February 1998, the Company primarily financed its operations through private
sales of capital stock (which, through December 31, 1997, totaled $10.5 million,
including $9.3 million raised in July and August of 1997), the private sale of
$5.8 million of the Series A Notes in November 1997, internally-generated cash
flow, advances from related parties and certain other short-term loans.
Net cash used in operating activities of $32.2 million for the nine months
ended September 30, 1998 was primarily attributable to a net loss of $30.8
million and an increase of $5.0 million in prepaid expenses partially offset by
a $2.2 million increase in accounts payable and depreciation and amortization of
$1.6 million. For the three months ended September 30, 1997, cash used in
operating activities of $738,000 resulted primarily from a net loss of $4.1
million largely offset by increases in accounts payable, depreciation and
amortization.
Net cash used by investing activities was $1.7 million for the nine months
ended September 30, 1998, and consisted of purchases of equipment of $2.3
million and $424,000 for the acquisition of superSonicBoom, Inc., partially
offset by the sale of short-term investments of $1.0 million. Net cash used in
investing activities of $2.0 million for the nine months ended September 30,
1997 was attributable to purchases of equipment of $1.3 million and to purchases
of short-term investments of $984,000, partially offset by sales and maturities
of short-term investments of $246,000.
Net cash provided by financing activities was $82.8 million for the nine
months ended September 30, 1998, and consisted largely of net proceeds of
approximately $88.7 million from the Company's 1998 public offerings, offset by
the retirement of $5.8 million of the Company's Series A Notes.
On September 2, 1998, the Company entered into a global merchant agreement
with Yahoo! Inc. (the "Yahoo! Agreement"), extending and expanding upon earlier
agreements with Yahoo! of August 1997 and March 1998. Under the Yahoo!
Agreement: (i) the Company continues to be granted music-retail exclusivity on
music-related search-results pages on Yahoo!'s main directory, www.yahoo.com,
(ii) is integrated into other areas of the Yahoo! Service, including Yahoo! Mail
and (iii) becomes the premier music retailer on many of Yahoo!'s international
Page 14
sites. The term of the Yahoo! Agreement ends on December 31, 2000, except for
presence on the international sites, which ends on March 31, 2000. The Company
may terminate the Yahoo! Agreement earlier upon payment of a specified
termination fee. Coincident with the Yahoo! Agreement, Yahoo! agreed to
purchase up to $2 million in newly-issued common shares of the Company, of which
half was invested in September 1998, and the remainder is to be invested as of
December 31, 1999.
The Company is required to pay aggregate minimum fixed fees of $9.3 million,
$27.4 million, $26.7 million and $3.6 million during the remaining three months
of 1998 and the years ending December 31, 1999, 2000 and 2001, respectively,
under the Company's marketing agreements and strategic alliances.
The Company expects to fund its future payment obligations under its marketing
agreements and strategic alliances from its cash and cash equivalents and from
cash generated from future operations and financing activities. As of September
30, 1998, the Company had $59.6 million of cash and cash equivalents. As of
that date, the Company's principal commitments consisted of obligations under
its strategic alliances as well as obligations outstanding under capital and
operating leases. Although the Company has no material commitments for capital
expenditures, it anticipates substantial increases in its capital expenditures
and lease commitments consistent with anticipated growth in operations,
infrastructure and personnel.
FACTORS AFFECTING THE COMPANY'S BUSINESS AND PROSPECTS
The Company expects to experience significant fluctuations in its future
quarterly operating results due to a variety of factors, many of which are
outside the Company's control. Factors that may affect the Company's quarterly
operating results include (i) its ability to retain existing customers, attract
new customers and maintain customer satisfaction, (ii) the introduction of new
or enhanced Web pages, services, products and strategic alliances by the Company
and its competitors, (iii) price competition or higher wholesale prices, (iv)
the level of use of the Internet and consumer acceptance of the Internet for the
purchase of recorded music, (v) seasonality of recorded music sales, (vi) its
ability to upgrade and develop its systems and infrastructure and attract
qualified personnel, (vii) technical difficulties, system downtime or Internet
brownouts, (viii) the amount and timing of operating costs and capital
expenditures relating to expansion of the Company's business, operations and
infrastructure, (ix) the timing of Company promotions and sales programs, (x)
the level of merchandise returns experienced by the Company, (xi) government
regulation and (xii) general economic conditions and economic conditions
specific to the Internet and the music industry.
The Company expects that it will experience seasonality in its business,
reflecting a combination of seasonal fluctuations in Internet usage and
traditional retail seasonality patterns affecting sales of recorded music.
Sales in the traditional retail music industry are significantly higher in the
fourth calendar quarter of each year than in the preceding three-quarters.
However, to date, the Company's limited operating history and rapid growth make
it difficult to ascertain the effects of seasonality on its business. The
Company believes that period-to-period comparisons of the Company's historical
results are not necessarily meaningful and should not be relied upon as an
indication of future results.
Risks Associated with the Year 2000. The Year 2000 issue is the result of
computer programs being written using two digits rather than four to define the
applicable year. In other words, date-sensitive software may recognize a date
using "00" as the year 1900 rather than the year 2000. This could result in
system failures or miscalculations causing disruptions of operations, including,
among others, a temporary inability to process transactions, send invoices, or
engage in similar normal business activities.
The Company does not believe that it has material exposure to the Year 2000
issue with respect to its own information technology since its existing systems
correctly define the year 2000. The Company's non-information technology
systems, which include, but are not limited to, systems such as security,
heating, ventilating and air conditioning systems and facsimile machines are not
considered by the Company to be date sensitive to the Year 2000 and, therefore,
do not raise Year 2000 issues.
Page 15
The Company is currently conducting an analysis to determine the extent to
which its major suppliers' systems (insofar as they relate to the Company's
business), including, but not limited to, the systems of credit card processors,
telecommunications providers, product distributors and companies with whom the
Company has strategic alliances, are subject to the Year 2000 issue. The
Company is currently unable to predict the extent to which the Year 2000 issue
will affect its suppliers, or the extent to which it would be vulnerable to the
suppliers' failure to remediate any Year 2000 issues on a timely basis. The
failure of a major supplier subject to the Year 2000 to convert its systems on a
timely basis or a conversion that is incompatible with the Company's systems
could have a material adverse effect on the Company. In addition, most of the
purchases from the Company's store are made with credit cards via the Internet,
and the Company's operations may be materially adversely affected to the extent
its customers are unable to use their credit cards or access the Internet due to
the Year 2000 issues that are not rectified by their credit card vendors or by
those organizations responsible for maintaining and providing access to the
Internet.
The Company intends to actively work with and encourage its suppliers to
minimize the risks of business disruptions resulting from Year 2000 issues and
develop contingency plans where necessary. Such plans may include, but are not
limited to, using alternative suppliers and establishing contingent supply
arrangements. The Company expects to have such plans in place by June 30, 1999.
Page 16
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
(a) On February 13, 1998, the Company consummated its initial public offering
(the "Offering") of its common stock, no par value (the "Common Stock"). The
registration statement relating to this offering (File No. 333-41241) was
declared effective on February 9, 1998. BT Alex. Brown and Nations Banc
Montgomery Securities LLC were the managing underwriters of the Offering. The
Offering terminated on March 4, 1998 upon the consummation of the sale of all of
shares subject to the underwriters' over-allotment option. The number of shares
registered, the aggregate price of the offering amount registered, the amount
sold and the aggregate offering price of the amount sold by the Company and
certain shareholders of the Company in the Offering were as follows:
Shares Aggregate Amount Sold Aggregate
------ --------- ----------- ---------
Registered Price Registered Price Sold
---------- ---------------- ----------
The Company 4,561,250 $72,980,000 4,561,250 $72,980,000
The Selling Shareholders 153,750 $ 2,460,000 153,750 $ 2,460,000
The Company incurred the following expenses with respect to the Offering
during the period February 13, 1998 through June 30, 1998, none which were
direct or indirect payments to directors, officers, general partners of the
Company or their associates or to persons owning 10% or more of any class of
equity securities of the Company or to affiliates of the Company:
Underwriting Underwriter's
Discounts -------------
And Commissions Finders' Fees Expenses Other Expenses Total Expenses
--------------- ------------- -------- -------------- --------------
$5,108,600 $0 $0 $703,538 $5,812,138
(b) On July 28, 1998, the Company consummated a secondary public offering of
its Common Stock (the "Secondary Offering"). The registration statement relating
to this offering (File No. 333-52367) was declared effective on July 28, 1998.
BT Alex. Brown was the managing underwriter of the Offering. The number of
shares registered, the aggregate price of the offering amount registered, the
amount sold and the aggregate offering price of the amount sold by the Company
and one shareholder of the Company in the Offering were as follows:
Shares Aggregate Amount Sold Aggregate
------ --------- ----------- ---------
Registered Price Registered Price Sold
---------- ---------------- ----------
The Company 1,250,000 $23,125,000 1,250,000 $23,125,000
The Selling Shareholder 80,000 $ 1,480,000 80,000 $ 1,480,000
The Company incurred the following expenses with respect to the Offering
during the period July 28, 1998 through September 30, 1998, none which were
direct or indirect payments to directors, officers, general partners of the
Company or their associates or to persons owning 10% or more of any class of
equity securities of the Company or to affiliates of the Company:
Underwriting Underwriter's
Discounts -------------
And Commissions Finders' Fees Expenses Other Expenses Total Expenses
--------------- ------------- -------- -------------- --------------
$1,212,500 $0 $0 $258,200 $1,470,700
Page 17
(c) On September 2, 1998, the Company sold 106,101 shares of its Common Stock
at a price of $9.425 per share to an accredited investor coincident with
entering into a strategic alliance with that investor. The net proceeds to the
Company were $1,000,000. The Company believes that this transaction was exempt
from registration under Section 4(2) of the Act because the subject securities
were sold to an accredited investor, which was purchasing for investment without
a view to further distribution.
(d) Use of Proceeds. The net offering proceeds to the Company after
deducting the foregoing discounts, commissions, fees and expenses were
$88,732,162. An estimate of how these proceeds were used by the Company during
the period February 9, 1998 through September 30, 1998 is as follows:
Construction of plant, building and facilities $ 0
Purchase and installation of machinery and equipment 2,481,088
Purchases of real estate $ 0
Acquisition of other businesses 423,694
Repayment of indebtedness 5,775,500
Online and Traditional Advertising 9,326,777
Strategic Alliances 10,707,315
Working capital 4,128,598
Temporary investments (money market account) 55,889,190
None of the foregoing expenses constituted direct or indirect payments to
directors, officers, general partners of the Company or their associates or to
persons owning 10% or more of any class of equity securities of the Company or
to affiliates of the Company
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
None
Page 18
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Exhibit
Number Description
- ------- -----------
3.1 Amended and Restated Articles of Incorporation of the Company.*
3.2 Amended and Restated Bylaws of the Registrant.*
3.3 Amendment No. 1 to Amended and Restated Bylaws of the Registrant*
27.1 Financial Data Schedule.**
* Incorporated by reference to the Company's Registration Statement on Form
S-1 (File No. 333-41241).
** Filed herewith.
Page 19
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CDNOW, INC.
(REGISTRANT)
Date: November 6, 1998 /S/ Jason Olim
---------------------------------------
Jason Olim
Chairman, President &
Chief Executive Officer
/S/ Joel Sussman
---------------------------------------
Joel Sussman
Vice President and
Chief Financial Officer
/S/ Joel Sussman
Joel Sussman
Vice President and
Chief Financial Officer
Page 20