<PAGE> 1
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, 2000
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 23-2979814
(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 registrant's classes of
common stock as of August 9, 2000: 32,961,610 shares of common stock, no par
value.
<PAGE> 2
CDnow, Inc.
INDEX
Page
Part I - Financial Information ----
Item 1. Financial Statements
Unaudited Consolidated Balance Sheets as of June 30, 2000 and
December 31, 1999....................................................3
Unaudited Consolidated Statements of Operations for the three and
six months ended June 30, 2000 and 1999..............................4
Unaudited Consolidated Statements of Cash Flows for the six months
ended June 30, 2000 and 1999.........................................5
Notes to Unaudited Consolidated Financial Statements.................6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations...........................................11
Item 3. Quantitative and Qualitative Disclosures About Market Risk..........17
Part II - Other Information
Item 1. Legal Proceedings...................................................18
Item 2. Changes in Securities and Use of Proceeds...........................19
Item 3. Defaults Upon Senior Securities.....................................19
Item 4. Submission of Matters to a Vote of Security Holders.................19
Item 5. Other Information...................................................19
Item 6. Exhibits and Reports on Form 8-K....................................19
Signatures....................................................................20
<PAGE> 3
PART I.
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CDNOW, INC. AND SUBSIDIARIES
UNAUDITED CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
June 30, 2000 December 31, 1999
--------------- -----------------
ASSETS
------
<S> <C> <C>
Current Assets:
Cash and cash equivalents $ 10,517,177 $ 20,612,706
Accounts receivable, net 3,385,637 4,809,931
Prepaid expenses and other 3,030,104 5,580,241
--------------- -----------------
Total current assets 16,932,918 31,002,878
--------------- -----------------
Property and equipment, net 13,500,450 17,216,980
Goodwill and other intangibles, net 53,666,937 70,121,321
Other assets 799,614 1,201,809
--------------- -----------------
TOTAL ASSETS $ 84,899,919 $ 119,542,988
=============== =================
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Current Liabilities:
Current portion of long term debt $ 1,596,196 $ 1,670,838
Accounts payable 24,153,567 46,431,122
Accrued N2K Inc. merger costs 2,181,263 4,300,117
Accrued expenses and other current liabilities 19,282,797 15,753,572
--------------- -----------------
Total current liabilities 47,213,823 68,155,649
--------------- -----------------
Long term debt 1,775,593 2,629,359
Deferred rent and other long term liabilities 1,792,152 992,696
Long term convertible debt 25,000,000 --
Common stock subject to put rights 2,999,995 2,999,995
COMMITMENTS AND CONTINGENCIES (Note 6)
STOCKHOLDERS' EQUITY:
Preferred stock, no par value, 50,000,000 shares
authorized, no shares issued and outstanding -- --
Common stock, no par value, 200,000,000
shares authorized, 32,813,965 and 30,355,948 issued
and outstanding 225,784,992 204,573,908
Additional paid-in capital 15,118,853 14,589,814
Deferred compensation (9,007) (61,905)
Accumulated deficit (234,776,482) (174,336,528)
--------------- -----------------
Total stockholders' equity 6,118,356 44,765,289
--------------- -----------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 84,899,919 $ 119,542,988
=============== =================
</TABLE>
The accompanying notes are an integral part of these statements.
<PAGE> 4
CDNOW, INC. AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
Three Months Ended June 30, Six Months Ended June 30,
------------------------------- ------------------------------
2000 1999 2000 1999
--------------- -------------- -------------- --------------
<S> <C> <C> <C> <C>
Net sales $ 34,017,692 $ 33,167,956 $ 77,600,841 $ 55,098,317
Cost of sales 26,498,247 28,000,743 62,602,263 45,984,318
--------------- -------------- -------------- --------------
Gross profit 7,519,445 5,167,213 14,998,578 9,113,999
Operating expenses:
Operating and development 7,558,458 5,827,207 18,147,838 9,553,389
Sales and marketing 11,284,549 20,231,717 34,806,427 37,370,391
General and administrative 2,813,017 3,362,400 5,762,525 4,733,756
Amortization of goodwill and other intangibles 8,188,194 8,144,055 16,385,217 9,481,681
--------------- -------------- -------------- --------------
Total operating expenses 29,844,218 37,565,379 75,102,007 61,139,217
--------------- -------------- -------------- --------------
Operating loss (22,324,773) (32,398,166) (60,103,429) (52,025,218)
Interest and other income 335,366 766,131 657,464 1,394,253
Interest expense (637,051) (88,242) (993,989) (192,862)
--------------- -------------- -------------- --------------
Net loss $ (22,626,458) $ (31,720,277) $ (60,439,954) $ (50,823,827)
=============== ============== ============== ==============
Basic and diluted net loss per common share $ (0.69) $ (1.06) $ (1.90) $ (2.04)
=============== ============== ============== ==============
Weighted average number of shares outstanding $ 32,723,051 $ 30,038,908 $ 31,732,731 $ 24,960,940
=============== ============== ============== ==============
</TABLE>
The accompanying notes are an integral part of these statements.
<PAGE> 5
CDNOW, INC. AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
Six Months Ended June 30,
2000 1999
---------------- ----------------
<S> <C> <C>
Operating Activities:
Net loss $ (60,439,954) $ (50,823,827)
Adjustments to reconcile net loss to
net cash used in operating activities:
Depreciation and amortization 20,020,479 12,124,299
Net loss on fixed asset disposals 1,310,488 --
Common stock options issued for services rendered 29,039 31,979
Increase (decrease) in operating assets and liabilities:
Accounts receivable 1,424,294 (1,785,111)
Prepaid expenses and other 3,052,307 5,193,536
Accounts payable (21,777,555) 4,496,676
Accrued expenses 976,637 (735,214)
Deferred revenue 380,028 225,385
Deferred rent liability 799,456 515,901
---------------- ----------------
Net cash used in operating activities (54,224,781) (30,756,376)
---------------- ----------------
Investing Activities:
Purchases of property and equipment (1,153,422) (1,633,771)
Cash acquired in acquisition -- 25,266,787
---------------- ----------------
Net cash provided by (used in) investing activities (1,153,422) 23,633,016
---------------- ----------------
Financing Activities:
Payments on term loans payable (68,720) (29,310)
Proceeds from the sale of stock 21,000,000 --
Proceeds from convertible debt 25,000,000 --
Payments on capitalized lease obligations (859,690) (481,712)
Proceeds from warrants exercised -- 102,352
Proceeds from options exercised 211,084 418,950
---------------- ----------------
Net cash provided by financing activities 45,282,674 10,280
---------------- ----------------
Decrease in cash and cash equivalents (10,095,529) (7,113,080)
Cash and cash equivalents, beginning of period 20,612,706 49,041,370
---------------- ----------------
Cash and cash equivalents, end of period $ 10,517,177 $ 41,928,290
================ ================
</TABLE>
The accompanying notes are an integral part of these statements.
<PAGE> 6
CDNOW, INC AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 -- BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements are presented in
accordance with the requirements for Form 10-Q and do not include all the
disclosures required by generally accepted accounting principles for complete
financial statements. Reference should be made to the Form 10-K as of and for
the year ended December 31, 1999 for CDnow, Inc. and subsidiaries for additional
disclosures including a complete summary of CDNOW's accounting policies.
In the opinion of management, the consolidated financial statements contain all
adjustments, consisting of normal recurring adjustments, necessary to present
fairly the consolidated financial position of CDNOW for the periods presented.
The interim operating results of CDNOW may not be indicative of operating
results for the full year or for any other interim period.
NOTE 2 -- THE COMPANY
CDNOW is a leading electronic commerce retailer of pre-recorded music, including
compact discs (CDs), cassettes and digital downloads, and other
entertainment-related products, including movies on VHS tape and DVD. CDNOW's
revenues are derived from the sale of pre-recorded music, other
entertainment-related products and advertising on the cdnow.com site. CDNOW
contracts with outside vendors for fulfillment services to deliver its products
to customers.
Since inception (February 12, 1994), CDNOW has incurred significant losses and
as of June 30, 2000 had accumulated losses of $234.8 million. For the six months
ended June 30, 2000 and 1999, CDNOW's net losses were $60.4 million and $50.8
million, respectively. In addition, CDNOW had a working capital deficit of $30.3
million as of June 30, 2000. CDNOW believes it will continue to incur
substantial operating losses for the foreseeable future. Because CDNOW has
relatively low product gross margins, achieving profitability depends upon its
ability to substantially increase net sales and improve gross margins. There can
be no assurance that CDNOW will be able to generate sufficient revenues or gross
margins to achieve or sustain profitability in the future.
During the second quarter of 2000, CDNOW financed its working capital needs with
cash derived from revenues, funds from the equity investment of $21 million by
Sony Music Entertainment Inc. ("Sony Music") and Time Warner Inc. ("Time
Warner") on March 16, 2000 and the long-term convertible debt facility,
available from Sony Music and Time Warner. As of July 13, 2000, CDNOW had
borrowed $30 million, the total amount available, under the convertible debt
facility. On August 3, 2000, as a result of the Convertible Loan Agreement with
Bertelsmann Inc.(see below), CDNOW repaid all of the principal and outstanding
accrued interest totalling approximately $31 million.
On July 19, 2000, CDNOW, Bertelsmann Inc. ("Bertelsmann"), and BINC Acquisition
Corp ("BINC"), a wholly-owned subsidiary of Bertelsmann, entered into an
Agreement and Plan of Merger under which Bertelsmann, through BINC, offered to
acquire all of the outstanding capital stock of CDNOW for $3.00 per share in
cash. A tender offer commenced on July 26, 2000 and is scheduled to expire on
August 22, 2000 at midnight (EDT). After expiration of the tender offer and
subject to certain conditions of the offer, all CDNOW shareholders that have
tendered and not properly withdrawn their shares will be paid $3.00 per share in
cash, BINC will merge with CDNOW, CDNOW will become a wholly-owned subsidiary of
Bertelsmann and all remaining CDNOW shareholders (who did not tender their
shares into the tender offer and have not exercised dissenter's rights) will
also receive $3.00 in cash for each of their shares. The transaction is subject
to customary closing conditions, including the tender of a majority of CDNOW's
outstanding common stock on a diluted basis and obtaining necessary regulatory
<PAGE> 7
approvals. The calculation of CDNOW's outstanding stock on a diluted basis will
include options and warrants to acquire CDNOW common stock with an exercise
price of $10 per share or less. The board of directors of CDNOW has unanimously
approved the merger agreement and has recommended to CDNOW shareholders that
they tender their shares into the proposed offer from Bertelsmann.
In addition to the Agreement and Plan of Merger, CDNOW and Bertelsmann entered
into a Convertible Loan Agreement. The Convertible Loan Agreement provides for
loans from Bertelsmann to CDNOW in an aggregate principal amount up to
approximately $43 million. On August 3, 2000, CDNOW used approximately $31
million available under the Convertible Loan Agreement to repay the debt plus
accrued interest owed to Sony Music and Time Warner. The $12 million remaining
under the Convertible Loan Agreement will be used to meet the working capital
needs of CDNOW during the period from July 31, 2000 through the earlier of
October 31, 2000 or the termination of the Convertible Loan Agreement.
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 inter-company
balances and transactions have been eliminated.
Reclassifications. The consolidated financial statements for prior periods have
been reclassified to conform to the current period's presentation.
Beginning in the first quarter of 2000, CDNOW elected to classify the
amount of coupons redeemed to purchase merchandise as a reduction to revenue
rather than the past practice of classifying coupons as a sales and marketing
expense. This change was made based on management's determination that
classifying coupons as a reduction to revenue was generally more consistent with
the current treatment of coupons by internet retailers. Accordingly, CDNOW made
a reclassification between net revenues and sales and marketing expense for the
three and six months ended June 30, 1999. Promotional coupons were approximately
$659,000 and $1.4 million for the three months ended June 30, 2000 and 1999,
respectively. Promotional coupons were approximately $3.5 million and $2.4
million for the six months ended June 30, 2000 and 1999, respectively. This
adjustment had no effect on net loss.
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, 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. CDNOW has presented net loss per common share amounts
for the three and six months ended June 30, 2000, pursuant to Statement of
Financial Accounting Standards No. 128 "Earnings Per Share."
Basic and diluted loss per common share was computed by dividing net loss
by the weighted average number of shares of common stock outstanding. Diluted
loss per share is the same amount as basic loss per share because the impact on
loss per share using the treasury stock method is anti-dilutive due to CDNOW's
losses.
Prepaid Expenses. CDNOW follows the American Institute of Certified Public
Accountants Statement of Position 93-7 "Reporting for Advertising Costs" ("SOP
93-7") to account for its marketing agreements. Under SOP 93-7, CDNOW amortizes
the costs associated with its marketing agreements 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. To the extent
additional payments are required to be made based on factors such as
click-throughs and new customers generated, such payments are charged to expense
as incurred. CDNOW evaluates the realizability of assets recorded, and if
necessary, writes-down the assets to its net realizable value. As of June 30,
2000, no such write-down was required.
<PAGE> 8
Prepaid expenses include approximately $1.5 million and $3.9 million at
June 30, 2000, and December 31, 1999, respectively, related to marketing
agreements (see Note 6). Other assets include the long-term portion of marketing
agreements of approximately $387,000 and $804,000 at June 30, 2000, and December
31, 1999, respectively.
Internally Developed Systems and Software. CDNOW follows Statement of Position
98-1 "Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use" ("SOP 98-1"), effective for fiscal years beginning after December
15, 1998. Accordingly, the costs of computer software developed or obtained for
internal use have been capitalized and are being amortized over the estimated
useful life of three years. At June 30, 2000 and December 31, 1999, net
capitalized computer software developed or obtained for internal use was
approximately $480,000 and $1.4 million, respectively. In the first quarter of
2000, CDNOW wrote-off approximately $1.3 million of previously capitalized
software costs related to the development of Cosmic Music Network, a
content-oriented site associated with the cdnow.com site, which focused on
unsigned bands and the promotion of their music. The decision to discontinue the
Cosmic Music Network was made as part of CDNOW's plan to prioritize its spending
following the termination of its proposed merger with Columbia House.
Common Stock Subject to Put Rights. America Online, Inc. ("AOL") and N2K Inc.
("N2K") a predecessor-in-interest to and, as of the merger of CDNOW and N2K, a
wholly-owned subsidiary of CDNOW, entered into an agreement pursuant to which
AOL agreed to purchase at N2K's initial public offering price per share of
$19.00 (less underwriting discounts and commissions) an aggregate amount of
approximately $3.0 million or 169,779 shares of N2K's common stock (the "AOL
Purchase"). Subsequent to the merger of CDNOW and N2K, the price per share
converted to $22.89 and the number of shares converted to 140,916 shares of
CDNOW common stock. N2K granted AOL certain shelf and other registration rights
with respect to the shares purchased by AOL, including the right to require N2K
to register such shares for resale, to have such registration statement declared
effective on or before April 16, 1998 and to maintain the effectiveness of such
registration statement for a period of two years from the consummation of the
AOL Purchase. As N2K had not caused such registration statement to be declared
effective by April 16, 1998, AOL has the right to require CDNOW, as a
successor-in-interest to N2K, to repurchase such shares for cash at a price
equal to the greater of the original purchase price or the then current fair
market value. Accordingly, the value of these shares is not included in
stockholders' equity. Presently, these shares have not been registered and AOL
has not exercised its put right. The common stock subject to put rights on
CDNOW's consolidated balance sheets will be accreted to its fair market value
based upon the price of CDNOW's common stock at each reporting date. The fair
market value will be recorded as a charge to retained earnings at each reporting
date and will reduce earnings available to common shareholders. The fair market
value of CDNOW's common stock as of June 30, 2000 was $3.0938 per common share.
As of June 30, 2000, there was no charge as the market value of CDNOW's common
stock was below $22.89 per common share.
Revenue Recognition. Net sales, which consist primarily of pre-recorded music
and other entertainment-related products sold via the Internet, include shipping
and handling charged to customers, and are recognized net of promotional
discounts and coupons when the products are shipped. CDNOW records a reserve for
estimated returns and customer credit, which is based on historical rates.
Revenue from the sale of advertising on the cdnow.com site is recognized as the
advertising is run.
CDNOW includes the revenue associated with barter advertising transactions
in net sales. The total amount of barter revenue included in net sales was
approximately $407,000 and $355,000 for the three months ended June 30, 2000 and
1999, respectively. For the six months ended June 30, 2000 and 1999, the total
amount of barter revenue included in net sales was approximately $1 million and
$745,000, respectively.
<PAGE> 9
Operating and Development. 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
fees for licensing of ratings, reviews, sound samples and other information.
Store maintenance costs are charged to expense as incurred.
Sales and Marketing. Sales and marketing expense includes expenses related to
marketing agreements, advertising and promotions, payroll and related expenses
for personnel engaged in marketing, selling, and customer service activities,
including internal and external commissions and service fees on advertising
revenue, and credit card processing fees. The expense associated with barter
advertising revenue is also included in sales and marketing expense. Advertising
costs are included in sales and marketing expenses and are charged to expense as
incurred. Advertising costs were approximately $4.4 million and $14.6 million
for the three months ended June 30, 2000 and 1999, respectively. For the six
months ended June 30, 2000 and 1999, advertising costs were approximately $14.2
million and $28.0 million, respectively. CDNOW pays commissions in the form of
merchandise credit or cash to the members of its Cosmic Credit and C2 affiliate
programs. Expenses related to these programs are included in sales and marketing
expenses.
Comprehensive Income. In June 1997, the Financial Accounting Standards Board
("FASB") issued Statement of Financial Accounting Standards 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. SFAS 130 is effective for
financial statements issued for fiscal years beginning after December 15, 1997.
CDNOW adopted SFAS 130 in the first quarter of 1998. CDNOW has had no other
comprehensive income items to report.
Segment and Geographic Information. In June 1997, the FASB issued Statement of
Financial Accounting Standards No. 131, "Disclosure About Segments of an
Enterprise and Related Information." This statement establishes additional
standards for segment reporting in the financial statements and is effective for
fiscal years beginning after December 15, 1997. CDNOW operates in one principal
business segment across domestic and international markets. No foreign country
or foreign geographic area accounted for more than 10% of net sales in any of
the periods presented. Substantially all of CDNOW's operating results and
identifiable assets are in the United States.
New Accounting Pronouncements. In December 1999, the Securities and Exchange
Commission issued Staff Accounting Bulletin No. 101, "Revenue Recognition in
Financial Statements" ("SAB 101"). SAB 101 summarizes certain of the Staff's
views in applying generally accepted accounting principles to recognition,
presentation and disclosure of revenue in financial statements. Compliance with
SAB 101 was required no later than the first quarter of the fiscal years
beginning after December 15, 1999. CDNOW determined that its revenue recognition
policies are in accordance with SAB 101.
NOTE 4 - LONG-TERM CONVERTIBLE DEBT
In connection with CDNOW's Agreement of Merger and Contribution with Sony
Corporation of America ("Sony") and Time Warner, CDNOW received a short-term
loan commitment from Sony Music and Time Warner. The short-term loan commitment
provided CDNOW with $30 million in working capital financing, drawable, based on
cash balance minimums, on or after December 16, 1999. On March 13, 2000, Sony,
Time Warner and CDNOW mutually consented to terminate the Agreement of Merger
and Contribution and entered into a Termination Agreement. Under the Termination
Agreement, Sony Music and Time Warner converted the $30 million short-term loan
commitment into long-term convertible debt. Borrowings under the convertible
loan bore interest at the six-month London interbank offered rate in effect two
days prior to the borrowing plus 3%. Principal and interest on the borrowings
were due no later than January 15, 2003. At any time, Sony Music and Time Warner
<PAGE> 10
had the option to convert any portion of the borrowings and accrued interest
under the convertible loan into CDNOW common stock at a conversion price of $10
per share. As collateral, Time Warner and Sony Music had a first security
interest in all of the assets of CDNOW. CDNOW had made borrowings of $25 million
and $0 as of June 30, 2000, and December 31, 1999, respectively. As of June 30,
2000, neither Sony Music nor Time Warner had converted any portion of the
borrowings or accrued interest into CDNOW common stock. The remaining $5 million
was borrowed on July 13, 2000. On August 3, 2000, as a result of the Convertible
Loan Agreement with Bertelsmann (see below), CDNOW repaid all of the principal
and outstanding accrued interest totalling approximately $31 million and the
rights of Sony Music and Time Warner to convert outstanding principal and
interest into CDNOW common stock were cancelled.
On July 19, 2000, CDNOW and Bertelsmann entered into the Convertible Loan
Agreement referenced in Note 2. The Convertible Loan Agreement provides for
loans of approximately $31 million from Bertelsmann to CDNOW to repay in full
all principal and accrued interest owed to Sony Music and Time Warner, which was
repaid on August 3, 2000. In addition, pursuant to the Convertible Loan
Agreement, Bertelsmann agreed to make additional loans ("Working Capital Loans")
to CDNOW in an aggregate amount up to $12 million during the period from July
31, 2000 through the earlier of October 31, 2000 or the termination of the
Convertible Loan Agreement. Working Capital Loans proceeds may only be used in
the ordinary course of business to meet ongoing working capital needs. Working
Capital Loans are only available if CDNOW's available cash balance falls below
$3 million and the aggregate principal amount of Working Capital Loans that
CDNOW may borrow in any four-week period is capped based on cash flow
projections that CDNOW has provided to Bertelsmann. Bertelsmann's commitment to
make Working Capital Loans to CDNOW terminates on the earlier of October 31,
2000, the date of the termination of the Agreement and Plan of Merger, or the
date any other person acquires control of CDNOW. On such date, the total
principal and interest borrowed from Bertelsmann under the Convertible Loan
Agreement is immediately due and payable, unless the Agreement and Plan of
Merger is terminated by CDNOW as a result of a breach by Bertelsmann, then such
amounts do not become payable until 60 days after such termination. The amounts
borrowed bear interest at the six-month London interbank offered rate in effect
two days prior to the borrowing plus 3%. CDNOW can make voluntary prepayments at
any time, without penalty. Prepayments are mandatory from the proceeds of any
sale, lease, transfer or disposition of property or equity securities, except
under certain defined exceptions. Bertelsmann may convert any portion of the
borrowings and accrued interest into CDNOW common stock at a conversion price of
$1.50 per share, provided that in no event shall Bertelsmann be entitled to
receive more than 49% of the outstanding CDNOW common stock on a fully-diluted
basis. As collateral, Bertelsmann has a first security interest in all of the
assets of CDNOW.
NOTE 5 - STOCKHOLDERS' EQUITY
On March 20, 2000, CDNOW re-priced issued and outstanding options to purchase
its common stock, no par value, held by its employees, officers and certain
members of its Board of Directors. Options having an exercise price greater than
$5.625, the closing price of CDNOW common stock on March 20, 2000, were
re-priced to an exercise price of $5.625. According to FASB Interpretation No.
44 "Accounting for Certain Transactions Involving Stock Compensation,"
reductions to the exercise price of a fixed option award must be accounted for
as variable from the date of the modification to the date the award is
exercised, forfeited or expires unexercised. Under variable accounting, a
compensation cost must be recorded based on the intrinsic value of the award,
which is computed as the difference between the exercise price and the fair
value of CDNOW's common stock on the date of the re-pricing. Thereafter, an
additional compensation cost must be recorded or reversed based on the
difference between the value of the option at the beginning and end of the
accounting period. The reversal of compensation cost cannot be larger than
accumulated compensation expense incurred. To date, no compensation expense has
been recognized as CDNOW's stock price has been below the new exercise price of
$5.625.
<PAGE> 11
NOTE 6 -- COMMITMENTS AND CONTINGENCIES
As of June 30, 2000, CDNOW's principal commitments consisted of obligations
under its marketing agreements and obligations associated with leased office
space and capital financing arrangements.
Payments Under Marketing Agreements. CDNOW is required to pay aggregate minimum
fixed fees of approximately $7.5 million and $2.8 million during the remaining
six months of 2000 and the year ending December 31, 2001, respectively, under
its existing marketing agreements. These minimum fixed fees primarily relate to
CDNOW's marketing agreement with America Online and the commitment to purchase a
minimum amount of advertising from MTV Networks. Depending on the type of
marketing agreement, CDNOW expenses advertising purchased under marketing
commitments when the advertising is run or amortizes the costs associated with
its marketing commitments 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.
Several of CDNOW's agreements contain provisions, which may require
additional payments 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 charged to expense as incurred. CDNOW continues to evaluate the
realizability of assets recorded under the agreements above and other
agreements, and, if necessary, will write down the assets to realizable value.
As of June 30, 2000, no such write down was required.
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 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 CDNOW'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, which may occur as a result of a variety of factors, including, but not
limited to, those set forth under the "Overview" and "Liquidity and Capital
Resources" sub-sections included in the Management's Discussion and Analysis of
Financial Condition and Results of Operations section of this document and in
the "Risk Factors" section of CDNOW's Registration Statement on Form S-4 (File
No. 333-72463), which was filed with the Securities and Exchange Commission
("SEC") on February 16, 1999. Particular attention should be paid to the
cautionary statements involving CDNOW'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, CDNOW's dependence on its marketing agreements 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, CDNOW undertakes no obligation to update any forward-looking
statement, whether as a result of new information, future events or otherwise.
Readers should carefully review the factors set forth in other reports or
documents that CDNOW files from time-to-time with the SEC and matters generally
affecting online commerce and online sale of entertainment-related products,
including, but not limited to, music retailing.
<PAGE> 12
Recent Developments.
On July 19, 2000, CDNOW, Bertelsmann Inc. ("Bertelsmann"), and BINC Acquisition
Corp ("BINC"), a wholly-owned subsidiary of Bertelsmann, entered into an
Agreement and Plan of Merger under which Bertelsmann, through BINC, offered to
acquire all of the outstanding capital stock of CDNOW for $3.00 per share in
cash. A tender offer commenced on July 26, 2000 and is scheduled to expire on
August 22, 2000 at midnight (EDT). After expiration of the tender offer and
subject to certain conditions of the offer, all CDNOW shareholders that have
tendered and not properly withdrawn their shares will be paid $3.00 per share in
cash, BINC will merge with CDNOW, CDNOW will become a wholly-owned subsidiary of
Bertelsmann and all remaining CDNOW shareholders (who did not tender their
shares into the tender offer and have not exercised dissenter's rights) will
receive $3.00 in cash for each of their shares. The transaction is subject to
customary closing conditions, including the tender of a majority of CDNOW's
outstanding common stock on a diluted basis and obtaining necessary regulatory
approvals. The calculation of CDNOW's outstanding stock on a diluted basis will
include options and warrants to acquire CDNOW common stock with an exercise
price of $10 per share or less. The board of directors of CDNOW has unanimously
approved the merger agreement and has recommended to CDNOW shareholders that
they tender their shares into the proposed offer from Bertelsmann.
In addition to the Agreement and Plan of Merger, CDNOW and Bertelsmann entered
into a Convertible Loan Agreement. The Convertible Loan Agreement provides for
loans from Bertelsmann to CDNOW in an aggregate principal amount up to
approximately $43 million. On August 3, 2000, CDNOW used approximately $31
million available under the Convertible Loan Agreement to repay the principal
and accrued interest borrowed from Sony Music and Time Warner. The $12 million
remaining under the Convertible Loan Agreement will be used to meet the working
capital needs of CDNOW during the period from July 31, 2000 through the earlier
of October 31, 2000 or the termination of the Convertible Loan Agreement.
Overview.
CDNOW is a leading electronic commerce retailer of pre-recorded music, including
CDs, cassettes and digital downloads, and other entertainment-related products,
including movies on VHS tape and DVD. Its early entry into the online music
retailing industry has helped CDNOW gain a well-recognized brand and a large
customer base. CDNOW's Internet site, 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 CDNOW's retail focus, revenues are primarily derived
from the sale of pre-recorded music and movies. CDNOW also sells advertising
space and sponsorships to companies interested in promoting their own goods and
services to CDNOW's customer base and the large number of visitors to CDNOW's
Internet site.
CDNOW has grown rapidly since its founding in 1994. Since inception,
approximately 4 million customers have made purchases from either CDNOW or from
Music Boulevard, the Internet music retail store previously operated by N2K,
which was integrated into the cdnow.com Internet site on May 17, 1999.
Approximately 270,000 customers made their initial purchase during the three
months ended June 30, 2000. CDNOW's net sales grew to $34.0 million during the
three months ended June 30, 2000, compared to $33.2 million during the three
months ended June 30, 1999. For the six months ended June 30, 2000, net sales
grew to $77.6 million, compared to $55.1 million during the six months ended
June 30, 1999.
In addition to the rapid acquisition of new customers, CDNOW has also generated
significant sales from existing customers. Repeat customers accounted for
approximately 72% of net sales during the three months ended June 30, 2000, up
from approximately 66% during the three months ended June 30, 1999. Repeat
customers accounted for approximately 69% of net sales during the six months
ended June 30, 2000, up from approximately 63% during the six months ended June
30, 1999. Since inception, CDNOW has incurred significant net losses and, as of
June 30, 2000, had accumulated losses of $234.8 million.
<PAGE> 13
CDNOW believes that the key factor affecting its financial success is
consummation of the transaction with Bertelsmann.
Results of Operations.
Three Months Ended June 30, 2000 Compared to the Three Months Ended June 30,
1999.
Net Sales. Net sales primarily reflect the sale of pre-recorded music and other
entertainment-related products, including outbound shipping and handling
charges. Net sales are net of a reserve for estimated returns and customer
credits, promotional discounts and coupons. Revenues from the sale of both cash
and barter advertising on CDNOW's Internet site are also included in net sales.
Net sales were $34.0 million for the three months ended June 30, 2000,
representing an increase of 2.6% over the three months ended June 30, 1999. This
increase is considerably less than prior quarter-to-quarter revenue growth due
to the substantial decrease in advertising spending in the second quarter of
2000. However, the 2.6% increase in net sales is attributable to increased sales
from repeat customers. During the second quarter of 2000, CDNOW devoted a
substantial portion of its marketing efforts to the retention of existing
customers. Repeat customer purchases represented approximately 72% of product
sales for the three months ended June 30, 2000, compared to approximately 66%
for the three months ended June 30, 1999. CDNOW's customer base on which
marketing efforts were focused was considerably larger during the second quarter
of 2000 compared to the same period in 1999. The total number of customers who
have made purchases at CDNOW or Music Boulevard since each site's respective
inception, was approximately 4 million as of June 30, 2000 and 2.4 million as of
June 30, 1999.
Beginning in the first quarter of 2000, CDNOW elected to classify the
amount of coupons redeemed to purchase merchandise as a reduction to revenue
rather than the past practice of classifying coupons as a sales and marketing
expense. This change was made based on management's determination that
classifying coupons as a reduction to revenue was generally more consistent with
the current treatment of coupons by internet retailers. Accordingly, CDNOW made
a reclassification between net revenues and sales and marketing expense for the
quarter ended June 30, 1999. Promotional coupons were approximately $659,000 and
$1.4 million for the three months ended June 30, 2000 and 1999, respectively.
This adjustment had no effect on net loss.
CDNOW also includes the revenue associated with cash and barter advertising
transactions in net sales. Cash and barter advertising revenue was $1.5 million
for the three months ended June 30, 2000 compared to approximately $1.9 million
for the three months ended June 30, 1999. The decrease in advertising revenue is
primarily attributable to potential advertisers' concerns regarding the
financial future of CDNOW. The total amount of barter revenue included in net
sales was approximately $407,000 and $355,000 for the three months ended June
30, 2000 and 1999, respectively. As a percentage of net sales, barter revenue
was 1.2% and 1.1% for the three months ended June 30, 2000 and 1999,
respectively.
International sales represented 18% of net sales for the three months ended
June 30, 2000 compared to 20% for the three months ended June 30, 1999. The
decrease in international sales as a percentage of net sales is primarily due to
increased competition in international markets.
Cost of Sales. Cost of sales consists primarily of the cost of merchandise
sold to customers, including product fulfillment and outbound shipping and
handling charges. Cost of sales decreased $1.5 million, to $26.5 million for the
three months ended June 30, 2000, from $28.0 million for the three months ended
June 30, 1999. CDNOW's gross margin increased to 22.1% for the three months
ended June 30, 2000 compared to 15.6% for the three months ended June 30, 1999.
The increase in gross margin is primarily attributable to improved shipping and
handling efficiencies and a less aggressive use of sales discounts and coupons,
partially offset by a decline in advertising revenue, which has a higher margin
than product sales.
<PAGE> 14
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 fees for licensing of ratings, reviews, sound samples and
other information. Store maintenance costs are charged to expense as incurred.
Operating and development expense increased by $1.8 million, or 29.7%, to $7.6
million for the three months ended June 30, 2000, compared to $5.8 million for
the three months ended June 30, 1999. As a percentage of net sales, operating
and development expense was 22.2% for the three months ended June 30, 2000,
compared to 17.6% for the three months ended June 30, 1999. The increase in both
dollar and percentage terms is attributable to increased staffing and associated
costs related to maintaining the features and functionality of CDNOW's online
site and transaction-processing.
Sales and Marketing Expense. Sales and marketing expense includes expenses
related to marketing agreements, advertising, barter advertising, promotions,
payroll and related expenses for personnel engaged in marketing, selling, and
customer service activities, including internal and external commissions and
service fees on advertising revenue, and credit card processing fees. Sales and
marketing expense decreased by $8.9 million to $11.3 million for the three
months ended June 30, 2000 compared to $20.2 million for the three months ended
June 30, 1999. As a percentage of net sales, sales and marketing expense was
33.2% for the three months ended June 30, 2000 compared to 61.0% for the three
months ended June 30, 1999. The decrease in both absolute dollars and percentage
terms was primarily attributable to a reduction in offline and online
advertising expense, including the termination after the second quarter of 1999
of a number of high fixed-cost marketing agreements with other internet sites.
Advertising costs were approximately $4.4 million and $14.6 million for the
three months ended June 30, 2000 and 1999, respectively. The decrease is also
attributable to the increased percentage of CDNOW's sales from repeat customers,
which are relatively less expensive than the cost of acquiring new customers.
General and Administrative Expense. General and administrative expense
consists of payroll and related expenses for executive and administrative
personnel, insurance, professional fees and other general and corporate
expenses. General and administrative expense decreased by approximately
$550,000, or 16.3%, to $2.8 million for the three months ended June 30, 2000,
compared to $3.4 million for the three months ended June 30, 1999. As a
percentage of net sales, general and administrative expense decreased to 8.3%
for the three months ended June 30, 2000 compared to 10.1% for the three months
ended June 30, 1999. The decrease in both dollar and percentage terms is
primarily due to a decrease in professional fees and a reduction in
merger-related costs incurred in connection with the terminated proposed merger
with Columbia House and the search for a new merger partner.
Amortization of Goodwill and Other Intangibles. Amortization of goodwill
and other intangibles related to the acquisition of N2K and superSonic Boom,
Inc. were approximately $8.2 million for the three months ended June 30, 2000
compared to $8.1 million for the three months ended June 30, 1999.
Six Months Ended June 30, 2000 Compared to the Six Months Ended June 30, 1999.
Net Sales. Net sales were $77.6 million for the six months ended June 30,
2000, representing an increase of 40.8% over the six months ended June 30, 1999.
Net sales for the six months ended June 30, 2000 include the sales to Music
Boulevard customers as a result of the acquisition of N2K on March 17, 1999. The
increase in net sales is attributable to increased sales from repeat customers,
continued growth of CDNOW's customer base, and increased advertising revenue.
During the first two quarters of 2000, CDNOW continued to devote a substantial
portion of its marketing efforts to the retention of existing customers. Repeat
customer purchases represented approximately 69% of product sales for the six
months ended June 30, 2000, compared to approximately 63% for the six months
ended June 30, 1999. The total number of customers who have made purchases at
CDNOW or Music Boulevard since each site's respective inception, which were
<PAGE> 15
available to CDNOW to focus its marketing efforts, was approximately 4 million
as of June 30, 2000 and 2.4 million as of June 30, 1999. Advertising revenue was
$4.6 million for the six months ended June 30, 2000, representing an increase of
62% from approximately $2.8 million for the six months ended June 30, 1999.
Beginning in the first quarter of 2000, CDNOW elected to classify the
amount of coupons redeemed to purchase merchandise as a reduction to revenue
rather than the past practice of classifying coupons as a sales and marketing
expense. This change was made based on management's determination that
classifying coupons as a reduction to revenue was generally more consistent with
the current treatment of coupons by internet retailers. Accordingly, CDNOW made
a reclassification between net revenues and sales and marketing expense for the
six months ended June 30, 1999. Promotional coupons were approximately $3.5
million and $2.4 million for the six months ended June 30, 2000 and 1999,
respectively. This adjustment had no effect on net loss.
CDNOW also includes the revenue associated with barter advertising
transactions in net sales. As a percentage of net sales, barter revenue was 1.3%
for the six months ended June 30, 2000 and 1999. The total amount of barter
revenue included in net sales was approximately $1 million and $745,000 for the
six months ended June 30, 2000 and 1999, respectively.
International sales represented 17% of net sales for the six months ended
June 30, 2000 compared to 20% for the six months ended June 30, 1999. The
decrease in international sales as a percentage of net sales is primarily due to
a proportionally larger increase in U.S. sales resulting from sales and
marketing efforts focused on the U.S. domestic market, such as CDNOW's
sponsorship of the 2000 Grammy Awards and a custom CD promotion with Pizza Hut.
The decrease is also due to a proportionally larger increase in U.S. sales from
Music Boulevard customers obtained as a result of the acquisition of N2K, which
derived a smaller percentage of its sales from international customers than
CDNOW, and to increased competition in international markets.
Cost of Sales. Cost of sales increased 36.1%, to $62.6 million for the six
months ended June 30, 2000, from $46.0 million for the six months ended June 30,
1999. The increase in percentage terms is due primarily to the 40.8% increase in
net sales, partially offset by the increase in gross margin. CDNOW's gross
margin increased to 19.3% for the six months ended June 30, 2000 compared to
16.5% for the six months ended June 30, 1999. The increase in gross margin can
be attributed to improved shipping and handling efficiencies and a less
aggressive use of sales discounts and coupons and an increase in advertising
revenue, which has a higher margin than product sales.
Operating and Development Expense. Operating and development expense
increased by $8.5 million, or 90%, to $18.1 million for the six months ended
June 30, 2000, compared to $9.6 million for the six months ended June 30, 1999.
As a percentage of net sales, operating and development expense was 23.4% for
the six months ended June 30, 2000, compared to 17.3% for the six months ended
June 30, 1999. The increase in both dollar and percentage terms is attributable
to increased staffing and associated costs related to maintaining the features
and functionality of CDNOW's online site and transaction-processing. The
increase is also attributable to the write-off in the first quarter of 2000 of
previously capitalized software costs in the amount of $1.3 million related to
the Cosmic Music Network, a content-oriented site associated with the CDNOW
store, which focused on unsigned bands and the promotion of their music. The
decision to discontinue the Cosmic Music Network was made as part of CDNOW's
plan to prioritize its spending following the termination of its proposed merger
with Columbia House.
Sales and Marketing Expense. Sales and marketing expense decreased by $2.6
million to $34.8 million for the six months ended June 30, 2000 compared to
$37.4 million for the six months ended June 30, 1999. As a percentage of net
sales, sales and marketing expense was 44.9% for the six months ended June 30,
2000, compared to 67.8% for the six months ended June 30, 1999. The decrease in
<PAGE> 16
both dollar and percentage terms was primarily attributable to a reduction in
offline and online advertising expense, including the termination after the
second quarter of 1999 of a number of high fixed-cost marketing agreements with
other internet sites. For the six months ended June 30, 2000 and 1999,
advertising costs were approximately $14.2 million and $28.0 million,
respectively. These reductions were partially offset by the costs of the custom
CD promotion with Pizza Hut, increased staffing and related costs in connection
with customer service activities necessary to support the increase in customer
base and the marketing and advertising sales strategy in place in the first
quarter of 2000, and increased credit card fees related to the growth in
revenues.
General and Administrative Expense. General and administrative expense increased
by $1.1 million, or 21.7%, to $5.8 million for the six months ended June 30,
2000, compared to $4.7 million for the six months ended June 30, 1999. As a
percentage of net sales, general and administrative expense decreased to 7.4%
for the six months ended June 30, 2000 compared to 8.6% for the six months ended
June 30, 1999. The increase in dollar terms is primarily due to the costs of
additional personnel to support the overall growth of CDNOW, increased
professional fees, and increased bad debt expense due to the growth in revenue.
The decrease in percentage terms is primarily due to efficiencies gained to
require less general and administrative expenses to support a higher revenue
base.
Amortization of Goodwill and Other Intangibles. Amortization of goodwill
and other intangibles related to the acquisition of N2K and superSonic Boom,
Inc. were approximately $16.4 million for the six months ended June 30, 2000
compared to $9.5 million for the six months ended June 30, 1999. The first
quarter of 1999 only included 15 days of amortization of goodwill and other
intangibles related to the acquisition of N2K, since the merger was not
completed until March 17, 1999.
Liquidity and Capital Resources.
At June 30, 2000, CDNOW's cash and cash equivalents were $10.5 million compared
to $20.6 million at December 31, 1999. Net cash used in operating activities of
$54.2 million for the six months ended June 30, 2000, was primarily attributable
to a net loss of $60.4 million, of which $20 million was a non-cash charge for
depreciation and amortization and $1.3 million was primarily related to a
write-off of capitalized software costs associated with the Cosmic Music
Network. Additional uses of cash included a net $20.8 million decrease in
accounts payable and accrued expenses due to payments to distributors related to
sales in the fourth quarter of 1999. These uses of cash were partially offset by
a $3.1 million decrease in prepaid expenses and other assets primarily due to
the expense of prepaid marketing agreements, a $1.4 million decrease in accounts
receivable due to a decrease in revenue compared to the fourth quarter of 1999,
and a $1.2 million increase in deferred revenue and deferred rent liability. Net
cash used in operating activities of $30.8 million for the six months ended June
30, 1999 was primarily attributable to a net loss of $50.8 million and an
increase of $1.8 million in accounts receivable as a result of increased
revenues. These uses of cash were partially offset by a $12.1 million non-cash
charge for depreciation and amortization, a $5.2 million decrease in prepaid
expenses and other assets primarily due to the expense of prepaid marketing
agreements, and a $3.8 million net increase in accounts payable and accrued
expenses due to an increase in accrued merchandise costs. The changes in working
capital exclude the impact of the acquisition of the assets acquired and
liabilities assumed of N2K as of the merger date, March 17, 1999.
Net cash used in investing activities was approximately $1.2 million for the six
months ended June 30, 2000, relating to the purchases of equipment and leasehold
improvements. Net cash provided by investing activities was $23.6 million for
the six months ended June 30, 1999, which consisted of $25.3 million in net cash
acquired from the acquisition of N2K, partially offset by purchases of equipment
of $1.6 million.
<PAGE> 17
Net cash provided by financing activities was $45.3 million for the six months
ended June 30, 2000. During the first quarter of 2000, Sony Music and Time
Warner purchased $21 million of CDNOW common stock and CDNOW borrowed $25
million under the long-term convertible debt agreement with Sony Music and Time
Warner. In addition, proceeds from the exercise of options amounted to
approximately $211,000. These increases in cash were partially offset by
approximately $928,000 of payments under capital lease and term loan
obligations. Net cash provided by financing activities was approximately $10,000
for the six months ended June 30, 1999 and consisted of proceeds from warrants
and options exercised of approximately $520,000, partially offset by payments on
capital leases and term loans of approximately $510,000.
As of June 30, 2000, CDNOW's principal commitments consisted of obligations
under its marketing agreements and obligations associated with leased office
space and capital financing arrangements. CDNOW is required to pay aggregate
minimum fixed fees under its marketing agreements of $7.5 million and $2.8
million during the remaining six months of 2000 and the year ending December 31,
2001, respectively.
Seasonality.
CDNOW experiences seasonality in its business, reflecting a combination of
seasonal fluctuations in Internet usage and traditional retail seasonality
patterns affecting sales of pre-recorded music and other entertainment-related
products. Sales in the traditional retail music industry are significantly
higher in the fourth calendar quarter of each year, which corresponds to the
holiday season, than in the preceding three quarters. Additionally, retail music
sales are traditionally hits-driven through popular releases by well-known and
emerging artists. The presence or absence of hits in any one quarter tends to
affect music sales.
ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK
Foreign Currency Risk.
CDNOW's revenues and expenses are denominated in United States dollars, with the
exception of revenues and expenses related to its Japanese Internet site.
Therefore, the only significant current exposure to foreign currency risk
relates to international sales. For the three months ended June 30, 2000 and
1999, international sales accounted for approximately 18% and 20% of net sales,
respectively. To the extent that the value of the United States dollar increases
relative to foreign currencies, it may be more costly for international
customers to make purchases. Therefore, changes in exchange rates may impact the
amount of CDNOW's international sales.
Interest Rate Risk.
CDNOW's exposure to market risk as a result of changes in interest rates relates
primarily to its investment portfolio. CDNOW invests its funds in instruments
that meet high credit quality standards, as specified in its investment policy.
This policy also limits the amount of credit exposure to any one issue, issuer
and type of investment.
As of June 30, 2000, all of CDNOW's investments were cash equivalents. Due to
the average maturity and conservative nature of its investment portfolio, a
sudden change in interest rates would not have a material effect on the value of
the portfolio. Management estimates that had the average yield of CDNOW's
investments decreased by one percent, its interest income for the six months
ended June 30, 2000 would have decreased by approximately $180,000. This
estimate assumes that the decrease occurred on the first day of 2000 and reduced
the yield of each investment instrument by one percent. The impact on CDNOW's
future interest income from future changes in investment yields will depend
largely on the gross amount of its investments.
<PAGE> 18
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On or about November 4, 1998, an action entitled Ticketmaster Ticketing Co. v.
N2K Inc., a wholly-owned subsidiary of CDnow, Inc., (Docket No. BC200194) was
filed against N2K in California Superior Court for the County of Los Angeles.
The Ticketmaster action alleges that N2K breached a marketing and advertising
contract dated April 23, 1998 between Ticketmaster and N2K, which N2K terminated
effective October 31, 1998, based on alleged breaches of the agreement by
Ticketmaster as well as other tortious conduct. Ticketmaster seeks damages in an
amount not less than $8,000,000, plus pre- and post-judgment interest, as well
as fees and costs. N2K filed a cross-complaint for affirmative relief. The
parties have completed discovery and trial is scheduled to begin in late
September.
N2K and 17 other entities have been named as defendants in a civil action
entitled Interactive Gift Express v. Compuserve, Inc., et al. (Docket 95 CV 6871
(BSJ)), which is pending in the U.S. District Court for the Southern District of
New York. The plaintiffs consented to entry of judgment against them in order to
speed their appeal of the court's ruling. The parties have appealed the matter
to the U.S. Court of Appeals for the Second Circuit.
N2K has been named as defendant in a civil action entitled Parsec Sight/Sound,
Inc. v. N2K Inc. (Docket 98 CV 0118), which is pending in the U.S. District
Court for the Western District of Pennsylvania. The plaintiff alleges
infringement of intellectual property rights and seeks treble damages and costs
in an unspecified amount as well as other declaratory and injunctive relief. In
this matter, discovery is ongoing. Additionally, Parsec has joined CDnow Online,
Inc., a wholly-owned subsidiary of CDnow, Inc., as a defendant. CDnow Online,
Inc. requested that Liquid Audio indemnify it against the Parsec claims,
pursuant to the indemnification provisions of the Order Fulfillment Agreement
entered into between CDnow Online, Inc. and Liquid Audio, Inc. as of October 20,
1999, and Liquid Audio has agreed to assume control of the costs of the defense
with reservation of certain rights. CDnow Online, Inc. expects to seek
indemnification from other parties that presently or will provide content or
services, which may be allegedly infringing the Parsec patents. The parties are
in the process of conducting discovery in preparation for trial.
CDNOW and N2K have been named defendants in an action brought by BPW Rhythmic
Records, L.L.C., which is pending in U.S. District Court for the Southern
District of New York in New York City for breach of contract and other related
claims arising out of a label agreement entered into between N2K Inc. and
Rhythmic Records on March 27, 1998. The plaintiff, Rhythmic Records, seeks
direct, punitive and exemplary damages, costs, including attorney's fees, and a
constructive trust against CDNOW's assets. The parties are in the process of
conducting discovery in preparation for trial.
On July 14, 1999, CDNOW filed a complaint against Lycos, Inc. and its
wholly-owned subsidiary Tripod, Inc., in the U.S. District Court located in
Philadelphia, Pennsylvania. The complaint alleges that Lycos and Tripod breached
their respective obligations to CDNOW as specified in the linking agreement
entered into among CDNOW, Lycos and Tripod on March 26, 1998. CDNOW seeks
damages in excess of $75,000 and a declaratory judgment terminating the linking
agreement. On November 15, 1999, Lycos and Tripod filed an answer and
counterclaim alleging breach of contract, quantum meruit and restitution, breach
of implied covenant of good faith and fair dealing and unfair and deceptive acts
and practices. Lycos and Tripod seek dismissal of the complaint, attorneys' fees
and damages as established at trial. The parties are in the process of
conducting discovery in preparation for trial.
<PAGE> 19
CDNOW is a party to other lawsuits and proceedings arising in the ordinary
course of its business, none of which, in CDNOW's opinion, is likely to have a
material adverse effect on operations.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
On July 12, 1999, CDNOW entered into an Agreement of Merger and Contribution
with Sony and Time Warner to combine its business with Columbia House. On March
13, 2000, Sony, Time Warner and CDNOW mutually consented to terminate the
Agreement of Merger and Contribution and entered into a Termination Agreement.
Under the Termination Agreement, Sony Music and Time Warner purchased $21
million of CDNOW's common stock (2,405,500 shares), no par value, on March 16,
2000, and replaced a $30 million short-term loan commitment with $30 million of
long-term convertible debt. As of June 30, 2000, CDNOW had borrowed $25 million
under the convertible debenture. On July 13, 2000, the remaining $5 million
available under the convertible loan agreement was borrowed. CDNOW is currently
using the proceeds to fund working capital requirements. As of June 30, 2000,
neither Sony Music nor Time Warner had converted any portion of the borrowings
or accrued interest into CDNOW common stock. On August 3, 2000, all principal
and accrued interest of approximately $31 million was repaid to Sony Music and
Time Warner, and the rights of Sony Music and Time Warner to convert outstanding
principal and interest under the Convertible Debt Agreement into CDNOW common
stock were cancelled.
On July 19, 2000, CDNOW, Bertelsmann, and BINC Acquisition Corp. ("BINC"), a
wholly-owned subsidiary of Bertelsmann, entered into an Agreement and Plan of
Merger under which Bertelsmann offered to acquire all of the outstanding capital
stock of CDNOW for $3.00 per share in cash. The tender offer commenced on July
26, 2000 and is scheduled to expire on August 22, 2000 at midnight (EDT). In
addition to the Agreement and Plan of Merger, CDNOW and Bertelsmann entered into
a Convertible Loan Agreement. The Convertible Loan Agreement provides for loans
from Bertelsmann to CDNOW in an aggregate principal amount up to approximately
$43 million. On August 3, 2000, approximately $31 million of loan proceeds drawn
under the Convertible Loan Agreement were used to repay all amounts due Time
Warner and Sony Music. The remaining $12 million will be used to meet the
working capital needs of CDNOW during the period from July 31, 2000 through the
earlier of October 31, 2000 or the termination of the Convertible Loan
Agreement. Bertelsmann may, at any time, convert any portion of the borrowings
and accrued interest into CDNOW common stock at a conversion price of $1.50 per
share, provided that in no event will Bertelsmann be entitled to receive more
than 49% of the outstanding CDNOW common stock on a fully-diluted basis. The
securities represented by the Convertible Loan Agreement have been offered and
sold in reliance upon Section 4(2) of the Securities Act of 1933, as amended.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
None
<PAGE> 20
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.
Date: August 14, 2000 /s/ Jason Olim
-----------------------------------
President and
Chief Executive Officer
/s/ Joel Sussman
-----------------------------------
Vice President, Treasurer and
Chief Financial Officer
