<PAGE>
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 June 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
-------------------------
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)
610 Old York Road, Suite 300, Jenkintown, Pennsylvania 19046
(Address of principal executive offices and Zip Code)
(215) 517 - 7325
(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 - 16,266,397 Shares Outstanding (July 24, 1998)
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CDnow, inc.
INDEX
Page
Part I - Financial Information
Item 1. Financial Statements
Unaudited Consolidated Balance Sheets as of June
30, 1998 and December 31, 1997................................... 1
Unaudited Consolidated Statements of Operations for the three
and six months ended June 30, 1998 and 1997...................... 2
Unaudited Consolidated Statements of Cash Flows for the six
months ended June 30, 1998 and 1997.............................. 3
Notes to Unaudited Consolidated Financial Statements............. 4
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations........................................ 8
Part II -
ITEM 1 Legal Proceedings...................................................14
ITEM 2 Changes in Securities and Use of Proceeds...........................14
ITEM 3 Defaults Upon Senior Securities.....................................15
ITEM 4 Submission of Matters to a Vote of Security Holders.................15
ITEM 5 Other Information...................................................15
ITEM 6 Exhibits and Reports on Form 8-K....................................16
Signatures....................................................................17
<PAGE>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CDnow, INC.
CONSOLIDATED BALANCE SHEETS
(unaudited)
<TABLE>
<CAPTION>
June 30, December 31,
1998 1997
------------- -------------
ASSETS
Current assets:
<S> <C> <C>
Cash and cash equivalents $ 47,290,625 $ 10,686,001
Short-term investments -- 1,003,045
Accounts receivable, net of reserve of $77,000 and $140,846 326,830 324,411
Prepaid expenses and other 5,423,757 2,457,958
------------ ------------
Total current assets 53,041,212 14,471,415
PROPERTY AND EQUIPMENT, NET 3,855,871 1,884,296
OTHER ASSETS 3,863,069 92,714
------------ ------------
$ 60,760,152 $ 16,448,425
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Notes payable $ -- $ 5,575,288
Current portion of term loans payable 60,315 54,091
Current portion of capitalized lease obligations 478,810 307,471
Accounts payable 3,510,308 8,981,430
Accrued expenses 1,482,007 579,413
Deferred revenues 83,200 188,466
Advances due to related parties -- 3,261
------------ ------------
Total current liabilities 5,614,640 15,689,420
------------ ------------
TERM LOANS PAYABLE 104,930 136,293
------------ ------------
CAPITALIZED LEASE OBLIGATIONS 994,005 825,851
------------ ------------
DEFERRED RENT LIABILITY 145,883 56,717
------------ ------------
REDEEMABLE SERIES A AND B CONVERTIBLE
PREFERRED STOCK -- 9,492,594
------------ ------------
COMMITMENTS AND CONTINGENCIES
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, 16,266,397 and
7,845,684 shares issued and outstanding 79,281,341 579,549
Additional paid-in capital 4,325,817 1,325,817
Deferred compensation (300,959) (434,776)
Accumulated deficit (29,405,505) (11,223,040)
------------ ------------
Total shareholders' equity (deficit) 53,900,694 (9,752,450)
------------ ------------
$ 60,760,152 $ 16,448,425
============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
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CDnow, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
1998 1997 1998 1997
------------ ------------- ------------- ------------
<S> <C> <C> <C> <C>
NET SALES $11,610,141 $ 2,964,625 $ 21,624,030 $ 5,546,203
COST OF SALES 9,600,049 2,363,302 18,154,598 4,412,843
----------- ----------- ------------ -----------
Gross profit 2,010,092 601,323 3,469,432 1,133,360
----------- ----------- ------------ -----------
OPERATING EXPENSES:
Operating and development 1,684,665 491,156 2,765,714 812,284
Sales and marketing 8,983,895 704,658 17,769,619 1,121,960
General and administrative 883,874 404,083 1,734,159 743,385
----------- ----------- ------------ -----------
11,552,434 1,599,897 22,269,492 2,677,629
----------- ----------- ------------ -----------
Operating Loss (9,542,342) (998,574) (18,800,060) (1,544,269)
INTEREST INCOME 722,012 -- 1,228,051 1,390
INTEREST EXPENSE (48,400) (6,805) (494,914) (6,805)
----------- ----------- ------------ -----------
NET LOSS (8,868,730) (1,005,379) (18,066,923) (1,549,684)
ACCRETION OF PREFERRED STOCK TO
REDEMPTION VALUE -- -- (115,542) --
----------- ----------- ------------ -----------
Net Loss Applicable to Common Shareholders $(8,868,730) $(1,005,379) $(18,182,465) $(1,549,684)
=========== =========== ============ ===========
Net Loss Per Common Share $ (0.55) $ (0.13) $ (1.29) $ (0.20)
=========== =========== ============ ===========
Weighted Average Number of Common Shares
Outstanding 16,074,787 7,845,684 14,044,939 7,845,684
=========== =========== ============ ===========
</TABLE>
The accompanying notes are an integral part of these statements.
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CDnow, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
<TABLE>
<CAPTION>
Six Months Ended
June 30,
1998 1997
---- ----
<S> <C> <C>
OPERATING ACTIVITIES:
Net loss $(18,066,923) $(1,549,684)
Adjustments to reconcile net loss to net cash used in operating activities--
Depreciation and amortization 750,610 129,000
Provision for returns and doubtful accounts 142,846 --
Increase in operating assets and liabilities--
Accounts receivable (140,185) 5,266
Prepaid expenses and other (1,597,421) (160,648)
Accounts payable (5,549,024) 722,118
Accrued expenses 902,594 339,604
Deferred revenue (105,266) (7,442)
Deferred rent liability
89,166 --
----------- ------------
Net cash used in operating activities (23,573,603) (521,781)
----------- ------------
INVESTING ACTIVITIES:
Sales and maturities of short-term investments 1,003,045 245,641
Purchases of property and equipment (1,637,206) (332,965)
Acquisition of a business (423,694) --
----------- ------------
Net cash used in investing activities (1,057,855) (87,324)
----------- ------------
FINANCING ACTIVITIES:
Borrowings on term loans payable -- 190,170
Payments on term loans payable (25,139) (6,478)
Borrowings on notes payable -- 50,000
Payments on notes payable -- (110,000)
Proceeds from sale of Common stock and warrants -- --
Proceeds from (repayment of) issuance of Series A Notes and warrants (5,777,500) --
Proceeds from sale of Preferred stock -- --
Proceeds from (repayment of) advances due to related parties (3,261) --
Payments on capitalized lease obligations (176,476) (21,012)
Proceeds from warrants exercised 59,890 --
Proceeds from options exercised 80,706 --
Proceeds from issuance of Common stock, net 67,077,862 --
----------- ------------
Net cash provided by financing activities 61,236,082 102,680
----------- ------------
INCREASE IN CASH AND CASH EQUIVALENTS 36,604,624 (506,425)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 10,686,001 775,865
----------- ------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 47,290,625 $ 269,440
=========== ============
</TABLE>
The accompanying notes are an integral part of these statements
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CDnow, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1 BASIS OF PRESENTATION
The consolidated financial statements of CDnow, Inc. and its subsidiaries (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 six month period ended June 30, 1998. These
consolidated financial statements should be read in conjunction with the
financial statements and notes thereto contained in the prospectus (the
"Prospectus") which is part of the Company's Registration Statement on Form S-1
(File No. 333-52367), as amended.
The interim operating results of the Company may not be indicative of operating
results for the full year.
2. THE COMPANY:
The Company is an online retailer of compact discs ("CDs") and other music-
related products. 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. The Company contracts with outside
warehouses for fulfillment services to deliver products to customers.
Therefore, the Company maintains no inventories.
Since inception (February 12, 1994), the Company has incurred significant
losses, and as of June 30, 1998 had accumulated losses of $30.9 million. For the
year ended December 31, 1997, and the six months ended June 30, 1998 the
Company's net loss was $10.7 million and $18.1 million, respectively. The
Company intends to invest 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
incur substantial operating losses for the foreseeable future, and that the rate
at which such losses will be incurred will increase significantly from current
levels. Because the Company has relatively low product gross margins, achieving
profitability given planned investment levels depends upon the Company's ability
to generate and sustain substantially increased revenue levels. There can be no
assurance that the Company will be able to generate sufficient revenues to
achieve or sustain profitability in the future. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations" in the Prospectus.
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
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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 for the three and six month periods
ended June 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 six months ended June 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.
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 primarily of payroll and related
expenses for store management, design, development, editorial, and network
operations personnel, systems and telecommunications infrastructure, and
royalties paid by the Company in return for licensing of ratings, reviews, 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 $490,486 and $13,992,087 for the six
months ended June 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 and, to date, have been immaterial. The Company estimates the amount of
unused credits and includes this amount in accrued expenses.
Initial Public Offering
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
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 approximately $67,077,862.
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
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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 six months ended June 30, 1997
and 1998, and accordingly this adoption has no impact on the financial results
of the Company for the three and six month periods ended June 30, 1997 and 1998.
Commitments and Contingencies
- -----------------------------
Yahoo Agreement. In August 1997, the Company entered into an agreement with
Yahoo! Inc. (the "Yahoo Agreement"), pursuant to which the Company was granted
exclusivity on music-related pages on the www.yahoo.com Web site. The term began
in October 1997 and will expire on October 5, 1999. During the first year of the
term, the Company is required to pay Yahoo $3,900,000 (of which $900,000 was
paid in 1997) in exchange for a specified number of page views. During the
second year of the term, the Company will be required to pay Yahoo an amount,
not to be less than $4,500,000, calculated using the number of impressions
delivered during August and September of 1998. The Company expects to amortize
the costs associated with the Yahoo Agreement over the contract term, with the
amortization method primarily based on the rate of delivery of a guaranteed
number of impressions to be received during the contract term. In connection
with the Yahoo Agreement, the Company paid Yahoo an additional $600,000 for
advertising in August and September 1997, which amount was charged to expense.
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 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 Company has agreed to pay
Excite a minimum of $4,500,000 over the contract term, of which $500,000 was
paid by December 31, 1997, $2,125,000 will be paid in 1998 and $1,875,000 will
be paid in 1999. The Company expects to amortize the costs associated with
Excite agreement over the contract term, with the amortization method primarily
based on the rate of delivery of a guaranteed number of impressions to be
received during the contract term.
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 which will commence on the
launch date, as defined. The Company has agreed to pay Lycos $4,500,000,
$5,500,000 and $6,500,000 during the first, second and third years,
respectively, of the contract term in exchange for a specified number of page
views. In addition, the Company has issued 61,665 shares (the "Lycos Shares") of
common stock to Lycos. The Lycos Shares vest as Lycos delivers certain required
minimum page views, as defined. 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 the Company will not be
required to make all of the minimum payments and all of the Lycos shares may not
vest. The Company expects to amortize the costs associated with the Lycos
Agreement over the contract term, with the amortization method primarily based
on the rate of delivery of a guaranteed number of impressions to be received
during the contract term.
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 branded Web services, as defined, in Europe. The Lycos Bertelsmann
Agreement has a three year term expiring in April, 2001. The Company has agreed
to pay Lycos Bertelsmann $1,420,000, $1,880,000 and $2,200,000 during the first,
second and third years of the contract term. The Company expects to amortize the
costs associated with the Lycos Bertelsmann Agreement over the contract term,
with the amortization method primarily based on the rate of delivery of a
guaranteed number of impressions to be received during the contract term.
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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
agreed to pay MTV Networks $5,200,000, $6,789,000, $7,336,000 and $121,000
during the remainder of 1998 and during the years ending December 31, 1999,
2000, and 2001, respectively. In addition, 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 will
occupy a premier position on certain pages of the GeoCities Web site. The
Company 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 and has expanded its agreement with Yahoo. The
Company's aggregate commitment under these arrangements is approximately
$3,088,000, $2,927,000, $2,435,000 and $766,000 in the remaining six months of
1998, and in the years ending December 31, 1999, 2000 and 2001, respectively.
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. No such payments have been incurred to date. Such
payments will be 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.
Safe Harbor for Forward-Looking Statements
- ------------------------------------------
From time-to-time, the Company may publish statements which are not 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.
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 results of those
anticipated depending on a variety of factors, including, but not limited to
those set forth under "Overview" and "Liquidity and Capital Resources" included
in this Management's Discussion and Analysis of Financial Condition and Results
of Operations 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.
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
This report contains, in addition to historical information, statements by the
Company with regard to its expectations as to financial results and other
aspects of its business that involve risks and uncertainties and may
constitute forward looking statements within the meaning of the Private
Securities Litigation Reform Act of 1995. Such statements reflect
management's current views and are based on certain assumptions. Actual
results could differ materially from those currently anticipated as a result
of a number of factors, including, but not limited to, those matters discussed
under "Management's Discussion and Analysis of Financial Condition and Results
of Operations" contained herein.
Overview
CDnow is the 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 569,000 customers
who have made purchases since inception through June 30, 1998, 273,000 made
their initial purchases during the six month period ended June 30, 1998.
Average daily visits to the CDnow store have grown from approximately 12,000 in
January 1996 to approximately 173,000 in June 1998. The Company's net sales
grew to $11.6 million in the second quarter of 1998 compared to $10.0 million
and $3.0 million in the first quarter of 1998 and the second 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 58% of net sales in the second 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 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 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.
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Since its inception, the Company has incurred significant net losses and, as of
June 30, 1998, had accumulated losses of $30.9 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 June 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 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.
The Company's business started as a sole proprietorship in February 1994. The
Company, which was incorporated in April 1995, was taxed as an S-corporation
until December 6, 1996 and has been taxed as a C-corporation since such date.
Results of Operations
The following table sets forth statement of operations data as a percentage of
net sales for the periods indicated:
<TABLE>
<CAPTION>
Three Months Six Months
Ended Ended
June 30, June 30,
-------- --------
1997 1998 1997 1998
------ ------ ------ ------
<S> <C> <C> <C> <C>
Net Sales 100.0% 100.0% 100.0% 100.0%
Cost of sales 79.7 82.7 79.6 84.0
------ ------ ------ ------
Gross profit 20.3 17.3 20.4 16.0
Operating Expenses:
Operating and development 16.6 14.5 14.6 12.8
Sales and marketing 23.8 77.4 20.2 82.2
General and administrative 13.6 7.6 13.4 7.9
------ ------ ------ ------
Total operating expense 54.0 99.5 48.2 102.9
------ ------ ------ ------
Operating loss (33.7) (82.2) (27.8) (86.9)
Interest income (expense), net (0.2) 5.8 (0.1) 3.3
------ ------ ------ ------
Net loss (33.9)% (76.4)% (27.9)% (83.6)%
====== ====== ====== ======
</TABLE>
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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 $146,200, $225,737, $45,535, $97,562,
$87,479 and $137,119, respectively, during the years ended December 31, 1996 and
1997, the three and six months ended June 30, 1997 and the three and six months
ended June 30, 1998, respectively. There were no Information Royalties paid in
1995. If Information Royalties were included in cost of sales, gross profit
margins would have been 14.9%, 16.3%, 18.7%, 18.7%, 16.6% and 15.4% during the
years ended December 31, 1996 and 1997, the three and six months ended June 30,
1997, and the three and six months ended June 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 $11.6 million and $21.6 million for the three
and six months ended June 30, 1998, representing increases of 292% and 290% 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 Grammy Awards promotion and
March 1998 storewide sale, as well as the continued implementation of its
strategic alliances. In the three and six months ended June 30, 1998, the
Company added approximately 137,000 and 273,000 new customers, bringing the
total number of customers since inception to 569,000 from 296,000 at December
31, 1997. International sales represented 22% of net sales for the three and
six months ended June 30, 1998 compared to 33% and 35% 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 $2.6
million and $4.7 million for the three and six months ended June 30, 1998 from
$1.0 million and $1.9 million in the corresponding periods of 1997.
Page 10
<PAGE>
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 also includes fees charged by credit card processors. Cost of
sales were $9.6 million and $18.2 million for the three and six months ended
June 30, 1998, compared to $2.4 million and $4.4 million for the corresponding
periods in 1997. The Company's gross profit margin decreased to 17.3% and 16.0%
for the three and six months ended June 30, 1998 compared to 20.3% and 20.4% 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 in the first quarter of 1998 in
connection with its Grammy Awards promotion and March 1998 storewide sale.
Gross margin for the quarter ended June 30, 1998 was 17.3% compared to 14.6% for
the quarter ended March 31, 1998; this increase was attributable to selective
price increases, reductions in international shipping costs and higher-margin
revenue from the sale of strategic sponsorships.
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 $1.7 million and $2.8 million for the three and six months ended
June 30, 1998 compared to $491,000 and $812,000 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 decreased to 14.5% and 12.8% for the
three and six months ended June 30, 1998 compared to 16.6% and 14.6% for the
three and six months ended June 30, 1997, as operating and development expenses
were spread over a larger revenue base.
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 $9.0 million and
$17.8 million for the three and six months ended June 30, 1998 compared to
$705,000 and $1.1 million for the three and six months ended June 30, 1997. As
a percentage of net sales, sales and marketing expense grew to 77.4% and 82.2%
for the three and six months ended June 30, 1998 compared to 23.8% and 20.2% for
the three and six months ended June 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 advertising costs incurred in the
first quarter of 1998 in connection with the Company's Grammy Awards and
American Music Awards promotions, costs associated with the Company's strategic
alliances, and promotional and public relations expenditures. The Company
increased its advertising expense to $6.7 million and $14.0 million for the
three and six months ended June 30, 1998 compared to $358,000 and $490,000 for
the three and six months ended June 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. The Company expects the dollar amount of sales and
marketing expense generally, and advertising expense in particular, to continue
to increase significantly in future periods. While the Company is hopeful that
its net sales will also increase in future periods so that its sales 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.
Page 11
<PAGE>
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 $884,000 and $1.7 million
for the three and six months ended June 30, 1998 compared to $404,000 and
$743,000 for the three and six months ended June 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 7.9% for the three and six months
ended June 30, 1998 from 13.6% and 13.4% for the three and six months ended June
30, 1997, as the Company's fixed costs were spread over a larger revenue base.
Page 12
<PAGE>
Net Loss. The Company's net loss was $8.9 and $18.1 million for the three and
six months ended June 30, 1998, compared to 1.0 and $1.5 million for the three
and six months ended June 30, 1997.
Liquidity and Capital Resources
At June 30, 1998 the Company's cash and cash equivalents were $47.3 million
compared to $269,000 at June 30, 1997. In February 1998, the Company
consummated its initial public offering, selling an aggregate of 4,561,250
shares 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 $23.6 million for the six months ended
June 30, 1998 was primarily attributable to a net loss of $18.1 million, a
decrease of $5.5 million in accounts payable and an increase of $1.6 million in
prepaid expenses, partially offset by a $903,000 increase in accrued expenses
and depreciation and amortization of $751,000. For the quarter ended June 30,
1997, cash used in operating activities of $522,000 resulted primarily from a
net loss of $1.5 million largely offset by increases in accounts payable and
other accrued expenses.
Net cash provided by investing activities was $1.1 million for the six months
ended June 30, 1998, and consisted of purchases of equipment of $1.6 million and
$424,000 of cash for the purchase of superSonicBoom, Inc. partially offset by
the sale of short-term investments of 1.0 million. Net cash used in investing
activities of $87,000 for the six months ended June 30, 1997 was attributable to
purchases of equipment of $333,000, partially offset by sales and maturities of
short-term investments of $246,000.
Net cash provided by financing activities of $61.2 million for the six months
ended June 30, 1998 consisted of net proceeds of approximately $67.1 million
from the Company's initial public offering offset by the retirement of $5.8
million of the Company's Series A Notes.
On May 18, 1998, the Company entered into a binding memorandum of terms with MTV
Networks (the "MTV/VH1 Agreement"). The Company is required to pay MTV Networks
$5.2 million, $6.8 million, $7.3 million and $121,000 in fixed fees during the
remaining six months of 1998 and the years ending December 31, 1999, 2000 and
2001, respectively. As additional consideration, the Company has granted MTV
Networks a warrant to purchase 226,892 shares of Common Stock at an exercise
price of $23.28 per share.
The Company is required to pay aggregate minimum fixed fees of $17.6 million,
$19.7 million, $17.9 million and $3.6 million during the remaining six months of
1998 and the years ending December 31, 1999, 2000 and 2001, respectively, under
strategic alliances.
The Company expects to fund its future payment obligations under its strategic
alliances from its cash and cash equivalents, including a portion of the net
proceeds from the Offering.
As of June 30, 1998, the Company had $47.3 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.
Page 13
<PAGE>
PART II
OTHER INFORMATION
ITEM 1. Legal Proceedings
None
ITEM 2. Changes in Securities and Use of Proceeds
(a) On May 18, 1998, the Company issued a warrant exercisable for 226,892
shares of Common Stock to an accredited investor as a partial inducement to
enter into a strategic alliance with the Company. 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.
(b) 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:
<TABLE>
<CAPTION>
Shares Aggregate Amount Sold Aggregate
------ --------- ----------- ---------
Registered Price Registered Price Sold
---------- ---------------- ----------
<S> <C> <C> <C> <C>
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
</TABLE>
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:
<TABLE>
<CAPTION>
Underwriting Discounts Underwriter's
-------------
and Commissions Finders' Fees Expenses Other Expenses Total Expenses
- ------------------------- ------------- -------- -------------- --------------
<S> <C> <C> <C> <C>
$5,108,600 $0 $0 $703,538 $5,812,138
</TABLE>
The net offering proceeds to the Company after deducting the foregoing
discounts, commissions, fees and expenses were $67,167,862. An estimate of how
these proceeds were used by the Company during the period February 9, 1998
through June 30, 1998 is as follows:
<TABLE>
<S> <C>
Construction of plant, building and facilities $0
Purchase and installation of machinery and equipment 1,637,206
Purchases of real estate --
</TABLE>
Page 14
<PAGE>
<TABLE>
<S> <C>
Acquisition of other businesses 423,694
Repayment of indebtedness 5,775,500
Online and Traditional Advertising 6,860,548
Strategic Alliances 3,470,779
Working capital 1,502,403
Temporary investments (money market account) 45,364,801
</TABLE>
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
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 certain MTV and VH1 programming and
obtained the right to use certain MTV and VH1 content. The Company has agreed to
pay MTV Networks $5,200,000, $6,789,000, $7,336,000 and $121,000 during the
remainder of 1998 and during the years ending December 31, 1999, 2000, and 2001,
respectively. In addition, 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.
Page 15
<PAGE>
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.**
* Filed herewith.
** Incorporated by reference to the Company's Registration Statement on Form S-1
(File No. 333-52367).
# Incorporated by reference to the Company's Registration Statement on Form S-1
(File No. 333-41241)
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<PAGE>
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: July 24, 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 17
