N2K Bull's Rebuttal
Louis Corrigan ([email protected])

Rick says that Music Boulevard has no brand and that Tower Records has been selling CDs to AOL members for years. Guess what? Tower is still on AOL, but you'll have trouble finding them. Go to the Music Channel. Want to buy the new Pearl Jam? Music Boulevard is the only vendor in sight. Out of sight, out of the e-commerce loop.

Real estate equals eyeballs equals brand. It's just about that simple, assuming the service is halfway decent. And guess what? Music Boulevard's service includes easy access to useful content. Want to see what Spin is saying about Madonna these days? No problem at musicblvd.com, big problem at CDNow or Tower or Amazon.

But what about Musicland <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MLG)") else Response.Write("(NYSE: MLG)") end if %>? Or healthier players such as Trans World? If you understand the economics behind Amazon, then you know that once you bracket concerns over brand and capital (as I think one should with N2K), then bricks and mortar are liabilities. Storefronts have been liabilities for years! Trans World is so healthy today because it has been so aggressive in closing stores. You think Blockbuster Video has had a hard time? I visit their music store next door just one out of every ten trips I make for a video. It's the music store that's a cavernous waste of space, with nowhere near Music Boulevard's selection and a zillion times the expenses.

Rick talks about maybe 15% gross margins. Well, if you back out one-time charges associated with N2K's record label, last quarter's gross margins were 28.1%. Yes, gross margins will remain low for the next couple of years as everybody discounts prices to gain eyeballs. But once the roster of players is established, gross margins will rise and stabilize. BancAmerica Robertson Stephens analyst Keith Benjamin is projecting N2K's gross margins will rise to 26.1% in FY99 and 28.4% in FY00. That's still way below Trans World's 36.7% margins, so price discounts are built into that model.

Mammoth marketing expenses will also fall as a percent of sales. And relative to its storefront competitors, any strictly online music vendor will have very low general and administrative expenses as a percent of sales.

Market share? The $480 million in sales by 2002 that I suggested would be just 3.6% of the overall recorded music market. Plus, greater bandwidth and improved functionality will keep Internet retailers growing fast enough to justify high PEs. Priced at 40 times earnings of $1.50 per share, then, N2K will need net margins of 6.25%. That seems quite possible.

Of course, the company also operates a record label, N2K Encoded Music. By FY99, it's anticipated that the label will contribute 10% of sales with 45% gross margins. Sure, maybe. But I think the risk/reward with N2K would look even better if the company just spun off this part of its content strategy.

And, oh yeah, N2K has some nifty technology for delivering digital music directly, so consumers will be able to just download CDs over the Web. Will this happen on a mass scale anytime soon? Probably not, but the company is at least prepared.

Next: The Bear Responds