Online music retailer CDNow and CD club Columbia House have called off their merger plans, first announced last July. CDNow claims that the plans didn't go through because Columbia House, which is owned by Sony Corp. and Time Warner, lacked the cash to cover CDNow's operating losses and investment plans--not because the merger was being examined by the Federal Trade Commission.

Monday's termination (3/13) shows that there has yet to be a full convergence between old-school, mail-order music services and Web retailers which now sell CDs but plan to enter the download market in the next several years.

In lieu of the merger, Time Warner and Sony will invest $21 million in CDNow and convert a previous short-term loan made to CDNow into a long-term debt, for a total investment of $51 million.

CDNow CEO Jason Olim said that his company decided to terminate the merger when CDNow executives discovered that Columbia House had more debt and less cash than they expected. CDNow, which is operating at a loss, wanted a strong merger partner to carry it through its operating losses and to fund new projects. The company will consider other partnerships, a new merger or even a buyout, Olim said.

The investment from Time Warner and Sony is supposed to help to do that, but CDNow will also cut its marketing and advertising costs by one-third, said chief financial officer Joel Sussman on an investor conference call on Monday (3/13). The company's gross revenue increased by 154 percent in the fourth quarter of 1999, but the company expects to earn less this year as a result of the cut, Sussman said. With the new $21 million investment, the company has $40 million in cash, enough to get it through the end of the year.

Time Warner and Sony representatives refused to comment on why they wanted to invest in CDNow, but it is likely that they want access to CDNow's customer information. CDNow's records of contain much more extensive demographic and preference information than any record company has ever collected through mail-in cards. A conservative industry, record companies have always been slow to use direct marketing, and they consider a database of email addresses and purchase information to be very valuable, said Charly Prevost, VP of promotions at Liquid Audio.

The investments have made some brick-and-mortar retailers concerned that the Warner Music Group and Sony Music will have stronger ties with CDNow than with them, according to Prevost. Although no one knows exactly how much of the music market will be distributed by downloads, brick-and-mortar retailers don't want to lose their portion of sales. Those who have both physical stores and retail websites will be in the best position to succeed, Prevost said.

A Warner Music executive also said that brick-and-mortar retailers were concerned about the new deal. However, the executive thought that the anxiety was inflated because the download market would only be a small percentage of the retail market over the next several years.

In the wake of the deal's collapse, one question remains: since America Online and Time Warner announced their merger after the CDNow-Columbia House merger, why didn't CDNow go through with the deal in order to get the backing of AOL? That could have given CDNow access to AOL's subscribers, even if Columbia House lacked the cash to fund CDNow.

Olim said in response that his company had "deeper relationships with Time Warner and AOL'' and would have future opportunities to expand its business with them. A company spokesperson could not specify exactly what those opportunities might be.

Another consequence of the termination will be that Columbia House will be on its own to move its 13 million mail order customers to its online systems, which have 3 million customers. Direct marketing through email is much cheaper than mailing out paper catalogs. E-commerce through a website also makes its easier and faster to process orders and ship them.

Last year, the FTC requested additional documents from CDNow and Columbia House when examining the proposed merger. CDNow denied that federal scrutiny was a factor in calling off the merger, and the company believes the deal would have been approved, according to Deborah Vondran, CDNow's director of corporate communications. A Sony Corp. spokesperson refused to comment on the FTC process, or whether the agency's investigation of alleged anti-competitive retail pricing by major labels Sony Music and Warner had any effect.