Update: CDnow, Columbia House Cancel Merger

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CDnow Inc. and Columbia House Inc. both said they expected to pursue an ongoing relationship to leverage each other's strengths in the wake of the March 13 cancellation of their merger agreement. In making the announcement, the two companies also disclosed their weaknesses, as Columbia House admitted its financial position has deteriorated since the merger agreement and CDnow said it would cut back on marketing to reduce its operating costs and would seek strategic advice from an outside consulting firm.

Several factors appeared to contribute to the dissolution of the merger, although Jason Olim, president of CDnow, Fort Washington, PA, said the primary reason was that Columbia House no longer appeared able to fund the growth of the combined companies.

"Their cash flow and debt level was not what we thought it was going to be when we first made this announcement back in July," Olim said. "We were all surprised by that."

He said a slowdown in Columbia House's business and revised financial projections from the company's new executive team made the deal unattractive to the shareholders of CDnow, a publicly traded company.

"There are a lot of contemporaneous facts that range from the phase of the moon to the fact that this was a very tedious process," Olim said. "The fact remains that this vehicle was not the right vehicle at this time."

A spokesman for Columbia House, a New York firm that is jointly owned by Sony Corp. and Time Warner Inc., confirmed that its financial position deteriorated in the last few months and attributed the change to the cyclical nature of the business.

According to some reports, the direct mail giant has been facing tough competition from online marketers and has suffered from declining consumer interest in membership clubs. The company also might have seen potential online synergies with the pending merger of Time Warner and America Online that made the CDnow deal appear less attractive.

Columbia House last month announced plans to reorganize its operations into three divisions to prepare for the CDnow merger and shift more of its offline business to an Internet-based environment. The reorganization involved the layoff of 87 people. At the same time, the company named a new team of executives and announced the departure of chairman and CEO Richard Wolter.

Meanwhile, CDnow said that it retained Allen & Co. to explore strategic options and that it would implement strategies to reduce its expenses, including its marketing costs. The company will focus on affiliate marketing, co-marketing with other advertisers and other strategies. Some reports indicated that CDnow is reacting to being out-muscled in the online music space by diversified e-commerce giant Amazon.com.

"We're competing with everyone who sells music," Olim said.

The company said it would reduce costs by almost one-third during the next quarter by cutting its marketing expenses and implementing other money-saving initiatives that will not include layoffs. The reduction in marketing will lower revenues and gross profits in the next quarter, the company said, but quarterly operating costs also will be reduced by $10 million to $12 million.

Olim said CDnow was still interested in tapping into the 16 million-member customer database of direct mail marketer Columbia House.

"Now that we are at arm's length, we are still pursuing the same objectives," Olim said. "Every [Columbia House] member spends $75 per year on music at retail - more than they do in the club."

He said he hoped to divert some of that spending to CDnow, which generated about $53.1 million in revenues during the fourth quarter and attracts about 800,000 visitors per day to its site.

CDnow also was continuing to talk with Sony and Time Warner about various things, including gaining access to their media outlets and to their labels and musical artists.

Under terms of their revised agreement, Sony and Time Warner will acquire about 2.4 million shares of CDnow's common stock, or about 8 percent of the company's outstanding shares, for $21 million. They also will convert a $30 million short-term loan into long-term debt that will be convertible to an ownership stake.

The original plan called for Sony and Time Warner to each own 37 percent of a new public company formed by the merger, with CDnow shareholders retaining the remaining 26 percent of the new company. In November the Federal Trade Commission began scrutinizing the deal for possible antitrust violations, but it was not clear to what degree that investigation played in the cancellation of the merger.

Olim said he was confident that the deal would have been approved soon anyway. He added that the new agreement would not require FTC approval.

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