Price: $15 7/8
Estimates (Dec) 1997A 1998E 1999E
EPS: d$3.25 d$4.01 d$3.25
P/E: NM NM NM
EPS Change (YoY): NM NM
Q2 EPS (June): d$1.13 d$1.09
Cash Flow/Share: NM NM NM
Price/Cash F low: NM NM NM
Dividend Rate: Nil Nil Nil
Dividend Yield: Nil Nil Nil
Opinion & Financial Data
Investment Opinion: D-2-1-9
Mkt. Value / Shares Outstanding (mn): $275.2 / 14.2
Book Value/Share (Mar-98): $3.26
Price/Book Ratio: $5.94
LT Liability % of Capital: NM
Est. 5 Year EPS Growth: NM
Stock Data
52-Week Range: $34-$12
Symbol / Exchange: NTKI / OTC
Options: Pacific
Institutional Ownership-Spectrum: 26.2%
ML Industry Weightings & Ratings**
Strategy; Weighting Rel. to Mkt.:
Income: Underweight (07-Mar-95)
Growth: Overweight (07-Mar-95)
Income & Growth: Overweight (07-Mar-95)
Capital Appreciation: Overweight (28-May-93)
Market Analysis; Technical Rating: Average (21-May-98)
**The views expressed are those of the macro department and do not
necessarily coincide with those of the Fundamental analyst.
For full investment opinion definitions, see footnotes.
Investment Highlights:
* N2K shares have recently declined sharply
(down 43% in two months) following a
secondary offering and weakness across the
group. We regard the current valuation as
attractive.
* For the purpose of this analysis, we have
applied a 2.5X multiple to our estimate for
N2K's 1999 revenues (of $175 million),
resulting in a 12-18 month price objective of
approximately $30 per share. We rate N2K
shares D-2-1-9, and recommend purchase at
current levels.
Fundamental Highlights:
* N2K is an online commerce company focused
on selling music over the Internet. The
company is widely acknowledged as a leading
source for online music content, community
and commerce.
* The company has secured some of the most
critical real estate on the Internet.
* Unlike many other online vendors selling
essentially commodity products, we believe
that N2K possesses a meaningful advantage in
the form of proprietary content and community.
Comment
United States
Information Processing - Internet Software & Svc
16 June 1998
Jonathan Cohen
First Vice President N2K Inc.
The Next Generation of Music Retailing
(Revised as of June 15, 1998)
ACCUMULATE
Long Term
BUY Reason for Report: Initiating Coverage
Merrill Lynch & Co.
Global Securities Research & Economics Group
Global Fundamental Equity Research Department
248900/248897/248100/248000 RC#20116705
Stock Performance
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1995 1996 1997 1998
N2K Inc.
Rel to S&P Composite Index (500) (Right Scale)
N2K Inc. - 16 June 1998
2
N2K Inc.
N2K is an online commerce company focused on selling
music over the Internet. The company is widely
acknowledged as a leading source for online music content,
community and commerce. N2K operates the Music
Boulevard Network, which includes both Music Boulevard
(which the company believes is the world's largest online
retail music site with more than 350,000 audio sound
samples and more than 200,000 titles available for sale) and
a broad range of other online music channels. The company
has secured some of the most critical real estate on the
Internet, and maintains either exclusive or preferred online
relationships with companies including America Online,
Netscape, Excite, WebTV, @Home, iVillage, AT&T
WorldNet, StarMedia, PointCast, CMT, TNN and MTV
International in Europe and Asia.
As we have discussed previously, we expect to see the
continued development of the portal model for Internet
commerce. That construct suggests that high volume Web
sites will increasingly serve as the principal aggregators of
content and commerce to the online consumer market. We
note that that model also suggests the capacity for a finite
number of portal providers, making the ownership of
N2K's online real estate increasingly valuable.
We believe that the opportunity to vend music over the
Internet is among the best-suited and most compelling
models within the Internet commerce space. Indeed, we
believe that Internet-based distribution of proprietary
intellectual property may be the purest application of the
medium. Here, the comparison between N2K and
Amazon.com becomes difficult to avoid. While we
applaud Amazon.com's successes and the company's
resulting dominance of the online bookselling sector, we
note that the distribution of music over the Internet is a
very much easily leveraged business: while books will
continue to require physical delivery for the foreseeable
future, music can be digitally distributed (downloaded)
today using existing and inexpensive technology.
Additionally, as the mechanisms for digital distribution of
music become more robust, we expect that N2K will be
able to further leverage an expanding consumer franchise.
We believe that the implications (specifically in terms of
operating margins) for companies able to successfully
combine online distribution of entertainment and media
assets with a strong consumer brand will be profound.
Unlike many other online vendors selling essentially
commodity products, we believe that N2K possesses a
meaningful advantage in the form of proprietary content
and community. As with America Online, the case can be
made that N2K provides not only a venue for online
commerce, but a legitimate destination site that should
attract customers despite the availability of nominally
similar services. N2K provides a wrapper of proprietary
content (in the form of chat, record reviews, concert and
artist information and exclusive music) around a
commoditized product (CDs). We believe that the
company's ownership of an independent record label (N2K
Encoded Music, run by Phil Ramone) provides it with a
unique position with regard to the ongoing acquisition of
music content for online distribution.
N2K's management is comprised of a group of individuals
from both the music and technology sectors. Larry Rosen,
the company's Chairman and CEO, was previously
President (and a co-founder) of GRP Records, an award-winning
contemporary jazz record label that was sold to
MCA in 1990 for $40 million. Dave Grusin, the company's
Vice Chairman, is a music industry pioneer who has
received 10 Grammys and several Oscars during his career.
Jon Diamond (Vice Chairman) was previously with Larry
Rosen at GRP Records and brings to the company a strong
background in both media and finance. Jim Coane, President
and Chief Operating Officer, joined Telebase systems (the
predecessor company of N2K) in April, 1987. Mr. Coane
was previously President of a leading supplier of
microcomputers and computer peripherals. Our point here is
that N2K has created an unusual and effective management
structure that combines expertise in both technology and the
music industry, and that the company has clearly focused on
those aspects that we believe will be most important to the
development of this sector.
We have spent considerable time with the company's
management team (since before their IPO), have been
consistently impressed with their focus on the music
specific - (as opposed to retail or technology oriented)
aspects of their business. We regard that focus as
representing a significant competitive advantage for N2K.
We believe that as Internet commerce becomes
increasingly pervasive, success will be defined as it is in
the physical world by operating scale, brand equity and a
company's enthusiasm for its business.
N2K has formed strategic partnerships with some of the
most important companies within the online commerce
space. The company has an agreement with CBS Cable
where N2K is the exclusive retailer for several of that
company's properties, Microsoft has entered into an
agreement with N2K that allows the company to operate as
a music tenant on Microsoft's Plaza, and in the retailing
areas for Microsoft's sites including www.microsoft.com
and MSN. N2K has structured additional agreements with
companies including MTV and Shinseido (a leading
Japanese retail chain), and we expect to see ongoing
partnerships consummated as N2K continues to expand the
scale of its operations.
The worldwide market for recorded music currently stands
at approximately $40.9 billion annually, and is expected to
grow to approximately $62.1 billion by the year 2002
(source: Market Tracking International, 1997). Within that
category, however, online recorded music revenues are
expected to account for an increasingly significant
component of total activity. According to Jupiter
Communications, the online component of music revenues
is projected to equal $179 million in 1998 and $2.8 billion
by 2002. We expect that a disproportionate measure of that
growth should accrue to a limited number of participants.
N2K Inc. - 16 June 1998
3
We fully expect that N2K will be included within that
group.
N2K has structured an operating strategy that focuses on
the three primary stages in the development of Internet
commerce: the Early Adopter, Rapid Acceptance and Mass
Market. The company initially allocated resources
towards building its infrastructure and creating a customer
base. Now, during a period in which the online commerce
sector is seeing rapid acceptance of transaction-based
models, N2K has focused on accelerating customer
acquisition, creating strong and defensible brand equity
and locking-up critical online real estate. Going forward,
the company's goal is to leverage the infrastructure it has
created to build the dominant (and profitable) online music
retailing franchise. We believe that the company is
moving strongly in that direction.
We believe that the continued propagation of
Internet/online-based commerce will represent a
compelling opportunity over the next decade. As with
Internet connectivity, we expect that Internet commerce
will become so ubiquitous over the next several years that
the distinction between physical and online commerce will
essentially disappear. In that environment, we believe that
those companies (such as N2K) able to establish
significant first-mover advantages and to secure primary
online real estate should generate disproportionately large
returns for their shareholders.
Our approach to valuation within the Internet space
relies upon the application of price/sales multiples to our
revenue projections for each of the companies we follow.
We note that that methodology represents a derivative
approach (and is built upon the structure of) a present
value/discounted cash flow analysis. For the purpose of this
analysis, we have applied a 2.5X multiple to our estimate for
N2K's 1999 revenues (of $175 million), resulting in a 12-18
month price objective of approximately $30 per share. We
note that at a 1.6X multiple to 1999 revenues, N2K is
currently selling at a significant discount to other online
commerce companies. Although there are clearly execution
risks associated with the company's growth rate, we believe
that the shares represent a excellent opportunity at these
prices. We rate N2K shares Accumulate/Buy, and
recommend purchase at current levels.
[NTKI] The securities of the company are not listed but trade over-the-counter in the United States. In the US, retail sales and/or distribution of this report may be made only in states where these securities are exempt from
registration or have been qualified for sale. MLPF&S or its affiliates usually make a market in the securities of this company.
Opinion Key [X-a-b-c]: Investment Risk Rating(X): A - Low, B - Average, C - Above Average, D - High. Appreciation Potential Rating (a: Int. Term - 0-12 mo.; b: Long Term - >1 yr.): 1 - Buy, 2 - Accumulate, 3 - Neutral, 4 -Reduce,
5 - Sell, 6 - No Rating. Income Rating(c): 7 - Same/Higher, 8 - Same/Lower, 9 - No Cash Dividend.
Copyright 1998 Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S). This report has been issued and approved for publication in the United Kingdom by Merrill Lynch, Pierce, Fenner & Smith Limited, which is
regulated by SFA, and has been considered and issued in Australia by Merrill Lynch Equities (Australia) Limited (ACN 006 276 795), a licensed securities dealer under the Australian Corporations Law. The information herein was
obtained from various sources; we do not guarantee its accuracy or completeness. Additional information available.
Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities or any options, futures or other derivatives related to such securities ("related investments").
MLPF&S and its affiliates may trade for their own accounts as odd-lot dealer, market maker, block positioner, specialist and/or arbitrageur in any securities of this issuer(s) or in related investments, and may be on the opposite side
of public orders. MLPF&S, its affiliates, directors, officers, employees and employee benefit programs may have a long or short position in any securities of this issuer(s) or in related investments. MLPF&S or its affiliates may from
time to time perform investment banking or other services for, or solicit investment banking or other business from, any entity mentioned in this report.
This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific
person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that
statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security's price or value may rise or fall. Accordingly, investors may receive
back less than originally invested. Past performance is not necessarily a guide to future performance.
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