STREET WISE by Amey Stone

MUSIC SALES VIA THE WEB: MOSTLY BLUES SO FAR

Shares of online bookseller Amazon.com (AMZN) have doubled in the past few weeks and have risen tenfold in the past year. That has left top online music retailers CDnow (CDNW) and N2K (NTKI) with a serious case of market envy. Shares of both companies have fallen by nearly half from their April highs as these companies have failed to meet Wall Street's earnings expectations and investors have grown increasingly worried about competition in this realm of cyberspace.

The upshot is that these stocks are a lot cheaper than some other E-commerce plays. And that could make them a buying opportunity -- in theory, at least.

As long as we're talking theory, selling compact discs over the Internet should be as lucrative as selling books. In fact, selling music is a natural for the Net. Online retailers can offer huge selection -- at least five times that of the average store -- 24 hours a day, at discounts of 10% to 20%. Shoppers can sample songs and link to recommendations, reviews, and news about their favorite acts. In theory, the wealth of information available on the Web should prompt music lovers to learn more about new performers and different genres and buy more music.

The only problem is that it seems the big payoff for music Web sites may not arrive until greater bandwidth allows music to be delivered via the Web. Whenever that happens -- probably several years from now -- buyers might be able to download songs onto their PCs and burn their own CDs. "That's clearly where we're going," says Ryan Jacob, manager of The Internet Fund. "It's just a question of how long it takes." Music is one of the few E-commerce products that truly can be delivered via the Internet, observes Jon Diamond, vice chairman and co-founder of N2K. "I don't envision you'll be able to download a bound book," he says.

The logic seems to make sense, but what's the timing? For now, online sales are at tiny fraction of sales in the $40 billion music industry, and competition between electronic retailers is intense. Online music sales were just $50 million in 1997 (by contrast, Amazon.com's revenues were $148 million). Still, Net music cheeleaders note that the figure was up threefold from a year earlier. And analysts cite projections by Jupiter Communications that online music sales could reach $4 billion by 2002. "There will be a number of strong players," says Andrea Williams, an analyst with Volpe Brown Whelan & Co.

Just as soon, that is, as music retailers figure out how to clear a few hurdles. "The negatives are the almost eye-popping amounts of red ink that will be generated (to start) and the high price of customer acquisition," says Steven B. Frankel at Adams, Harkness & Hill, who on June 19 put out an "accumulate" rating on the two leading online music purveyors, CDnow and N2K. Why would he do that? Because "today we're in a stage where investors are willing to tolerate Internet plays where profitability is far away." Translation: They'll gamble.

But on who? There are dozens of music sellers online. And there's no counterpart to Amazon.com for books or Preview Travel (PTVL) for travel; that is, there's no clear market leader. That has led to price wars and the need for music companies to spend more than expected on building brand recognition. For the moment, CDnow, which sells music through cdnow.com, and N2K, which operates Music Boulevard (www.musicblvd.com) as well as satellite sites providing music-related content, are on top. "In our opinion, the leaders of today should be able to maintain that leadership position," says Williams.

CDnow and N2K both have market caps around $300 million, despite paltry revenues and daunting losses. For the quarter ended in March, CDnow generated $10 million in sales and N2K reaped $7 million in revenues. CDnow lost $9.2 million, or 78 cents per share, and N2K lost $13.7 million, or $1.13 per share. Analysts don't expect either company to turn profitable until that magic year -- 2002.

So far, stock prices have reflected the standard boom-bust cycle of many initial public offerings. Momentum investors with high hopes ran the shares up to a high of 39 for CDnow and 34 5/8 for N2K by mid-April. Then, just as technology stocks began to fall across the board, these companies reported results that fell short of Wall Street's expectations. For CDnow, analysts expected a loss of 67 cents a share. For N2K, they were expecting a loss of $1.04. When both companies missed their projections, their shares plummeted.

CDnow hit a recent low of 16 on June 3, the day it announced that it was canceling its proposed secondary offering. Jason Olim, CDnow's president and CEO, says the company didn't need the cash immediately. Although there was plenty of interest in the offering, he says, "the stock price was not appropriate." The stocks recovered a bit in early June, but then fell to new lows after Amazon.com announced on June 11 that it would start selling CDs online. CDnow closed on June 11 at 17 and N2K bottomed out at 14 æ on June 16.

That's when Wall Street started to take notice. Several analysts issued buy recommendations, based partly on CDnow and N2K's low valuations relative to their Internet peers. On June 24, analyst Williams of Volpe Brown issued "buy" ratings in new coverage of both stocks. CDnow was trading at 1.1 times Williams' 1999 revenue estimates and N2K was trading at 1.0 times her 1999 revenue estimates, while a comparable group of Internet stocks was trading at 3.6 times. Her 12-month price target is 33 for N2K and 30 for CDnow.

Both stocks have recovered a bit already, as technology shares in general have rebounded from their May through mid-June slump. CDnow closed on July 1 at 20 5/8 and N2K closed at 19 5/8 that day. But there is still plenty of opportunity to buy on "short-term weakness," says Internet Fund manager Jacob.

Indeed, both N2K and CDnow face major risks: barriers to entry in their business are low, large "bricks and mortar" music retailers such as Tower Records and Musicland Stores (MLG) could make more of a push online, and the online companies could run out of cash before they can turn a profit. But such are the risks of all E-commerce plays. And the shares of music retailers are less expensive than many Internet stocks, while offering just as much, if not greater, promise for the future.

So, which one should you buy? N2K or CDnow? To find out, tune in tomorrow.

Amey Stone is an associate editor of Business Week Online