April 12, 2001
Major Business News
Bertelsmann Tries to Tune Into the Web
But Finds It to Be a Jarring Experience
By MARTIN PEERS and WILLIAM BOSTON
Staff Reporters of THE WALL STREET JOURNAL
Bertelsmann AG Chief Executive Thomas Middelhoff was triumphant when he broke ranks with his fellow music moguls last fall and announced a surprise alliance with Napster Inc. (www.napster.com1 ), the renegade Web service.
"The deal with Napster is courageous and visionary," he told Bertelsmann employees in an internal memo, and "represents a milestone for the music industry and for the digital distribution of music over the Internet."
But now it's looking like just another dead end. Last week, Vivendi Universal SA and Sony Corp. announced they are joining forces with Yahoo! Inc. to offer a new online music service. And Bertelsmann itself jumped into an alliance with AOL Time Warner Inc. and EMI Group PLC to sell music online through a joint-venture with RealNetworks Inc. Both initiatives aim to outflank Napster -- whose viability is in doubt following adverse court decisions -- but face high hurdles in their bids to deliver easy downloads of music to an impatient public.
Bertelsmann's strategy speaks volumes about the industry's muddled efforts to harness the Internet without being done in by the medium's power. Some executives are raring to go, while others are gripped by the fear that new digital services might lead consumers to spend less. It's a debate raging inside not just Bertelsmann, but all of the big media companies that own major record labels.
The upshot: Last year, record companies were projected to sell a meager $9 million in downloaded music, according to researcher Jupiter Media Metrix, a tiny fraction of the $14 billion in overall U.S. music sales.
The 47-year-old Mr. Middelhoff was an early Internet enthusiast, even writing his doctoral dissertation on a pioneering German online effort. As Bertelsmann's head of corporate development, he engineered the company's $50 million investment in America Online in 1994, which, together with a subsequent stake in AOL Europe, turned into a bonanza worth billions of dollars. Since becoming chief executive in 1998, he has pushed all of the entertainment giant's businesses to adapt quickly to the Internet. He launched BOL.com2 , which sells books and music online outside the U.S., and also presides over a roughly 40% stake in bookseller Barnes & Noble.com Inc. Both ventures have struggled somewhat.
But his efforts to bring Bertelsmann's BMG Entertainment into the Internet Age have struggled to strike the right notes. BMG, home to Arista Records and RCA, and such artists as Whitney Houston and Christina Aguilera, has been in turmoil in recent months. Clashes over Internet strategy were followed by a wholesale departure of top music executives, coinciding with a downturn in BMG's basic recording business. And the Napster deal has distanced the company from its peers.
Mr. Middelhoff concedes that progress hasn't been "as speedy as I would like." He complains that the record industry, which he refers to as the "music mafia," spends too much time defending old business methods rather than embracing the Internet. He says it's too early to count out Napster -- a Redwood City, Calif., service that drew the music industry's ire by enabling consumers to swap music online without paying for it. And he remains optimistic that his company will ultimately tame the Web.
"You have to build bridges between the different divisions" to deal with conflicts over the Web, Mr. Middelhoff says. "I learned that despite the fact that you have to accept a lot of frustration, it's possible."
Bertelsmann has been one of the most aggressive entertainment companies in developing an Internet music strategy. Its efforts go back to about 1996, when its BMG Entertainment unit launched a series of music sites based on genres like hip-hop and country music to promote BMG artists. BMG later joined with Universal Music Group, now part of Vivendi Universal, to create a site with access to more music.
But the venture, GetMusic LLC, provided an early lesson in how difficult it would be to execute a Web music strategy, as the two sides bickered over issues such as whether Universal and BMG would make their artists available for exclusive interviews. Within Bertelsmann, another debate raged: whether the site should emphasize promotion of music through use of music news and video clips, or whether it should focus on online CD sales, which people involved say Mr. Middelhoff preferred. Mr. Middelhoff says he didn't get involved in discussions of GetMusic strategy.
After long delays, GetMusic turned into something akin to an online music magazine, with a goal of helping consumers find the best in new music. But Mr. Middelhoff has decided to bail out, and Bertelsmann is now negotiating to sell its stake in the venture to Vivendi Universal.
Last year, Mr. Middelhoff restructured Bertelsmann, creating a new e-commerce group charged with online retailing of both music and books. Group head Andreas Schmidt, an electronic-media executive who had earlier been with Bertelsmann's Gruner + Jahr magazine division, quickly went on the acquisition trail, buying online CD retailer CDnow Inc. for about $100 million.
The Beatles on One CD
BMG was also trying to accommodate the rapidly evolving Web music marketplace. The Web had become a haven for music enthusiasts early on because it made pirated and independent music easily available -- and free -- through so-called MP3 files. MP3 is a technology for putting music in an Internet-friendly form by compressing it so tightly that all the recorded music of the Beatles could fit on one CD.
At BMG and other record companies, executives have worked since the late 1990s to figure out ways to sell albums through downloads. To prevent people from copying the downloads and sending the copies to others, the executives had to order up software to encrypt the music. They also had to devise systems for consumers to pay for music. It took BMG months to decide on technologies and to come up with a list of Web retailers who would sell the downloads.
So far, BMG's sales effort has been a dud. Despite an initial flurry of interest, only a handful of sites now offer downloads, including Alliance Entertainment's TheStore24, which provides Web-based retail functions for individual stores. Web executives complain that the system was hard to use and prone to breaking down during a transaction.
Even Bertelsmann's own Mr. Schmidt acknowledges that sometimes when a consumer tries to download from BMG, "your computer crashes." The drive to protect copyrights has resulted in a system that fails to deliver what consumers want, he says, adding that it's "only music," not the "secrets of the United States."
That is the thinking that led to Bertelsmann's surprising alliance with the music-industry's top enemy -- Napster, the file-sharing service that arrived on the scene in late 1999 with free, easy-to-use software that made it possible for computer users all over the world to swap MP3 files. The notorious service eventually attracted tens of millions of regular users -- and the rabid attention of the recording industry, which in December 1999 filed a lawsuit to shut Napster down for violating its copyrights.
Five months later a federal judge in San Francisco stripped Napster of key defenses it offered against the lawsuit. New Napster Chief Executive Hank Barry made the rounds of the record companies. He proposed charging Napster's users a monthly fee for downloading music. In exchange for the right to offer music legally, he would pay the music companies a share of the fees. He made little progress.
Among the skeptics were executives of BMG, which was a party to the lawsuit against Napster. But Mr. Middelhoff was increasingly taken with Napster's popularity. Last May, he asked students in a packed Stanford University lecture hall to raise their hands if they were Napster users. Nearly every hand went up. By August, he was telling a conference in Cologne, Germany, that the music industry "underestimated the impact and speed of the Internet" and had failed to develop a "forward strategy." He criticized the ability of recording industry marketers to court Net-savvy kids, asking: "Are they all criminals?"
Mr. Middelhoff soon arranged a meeting with Mr. Barry, and over the next eight weeks, the two sides hammered out a deal through Mr. Schmidt's e-commerce group. Bertelsmann would lend Napster money to help it develop a legitimate service. If Napster actually created such a service, BMG would license music to it. Mr. Middelhoff didn't bring BMG executives such as its chief executive, Strauss Zelnick, into the talks until later. When he did, the discussions were tense.
Mr. Zelnick argued that Napster probably would get no cooperation from the other record companies and would likely be closed down by the courts anyway. When Mr. Schmidt argued that Napster's legion of "customers" couldn't be ignored, Mr. Zelnick shot back that "until they open their wallets, they're not customers," according to people in the room.
Against Withdrawing
Mr. Schmidt says he doesn't recall referring to Napster's users as customers. Mr. Middelhoff, who confirms the exchange, says he initially wasn't able to bridge the gulf between Messrs. Schmidt and Zelnick, but the Napster deal was eventually renegotiated with input from the music executives. The original terms called for BMG to withdraw from the industry lawsuit against Napster as part of a broader deal in which Bertelsmann would make a loan to Napster. The BMG executives strongly resisted withdrawing from the lawsuit. Eventually the two sides agreed BMG would exit the litigation and license its music to Napster once another major label and an independent record label agreed to license their music to the service. (Napster has signed up two independents so far.) Bertelsmann ultimately lent Napster $60 million, convertible into equity after the music licenses have been granted, according to people familiar with the matter.
To try to enlist the other companies, Mr. Middelhoff personally met with counterparts like Vivendi Universal Chairman Jean-Marie Messier. But none of the other big media companies has agreed. "Thomas believes this is a viable business model, but I am not convinced of this," said Sony Chairman Nobuyuki Idei at a conference in Switzerland.
Bertelsmann's deal with Napster similarly infuriated some of BMG's artists. An up-and-coming rhythm-and-blues singer named Usher delayed release of his much-anticipated new album on an Arista label after discovering an unreleased track from the album on Napster. He went back into the recording studio to lay down new tracks, according to his manager and mother, Jonnetta Patton. "I totally disagree with them joining Napster," she says in an interview, and called BMG to tell the company as much. An Arista spokeswoman says Usher's album is now scheduled for release Aug. 7.
The industry's stance against Bertelsmann's Napster play hardened after an appeals court ruled in February that Napster had to take pirated music off its service. A few days later, Mr. Barry and Bertelsmann went public with a new version of their proposal to the labels, offering the industry, including independents, a minimum guarantee of $200 million per year to use their music on Napster, rather than giving them a percentage of the business.
Sony, Universal and AOL Time Warner all quickly dismissed the idea. On the surface, the financial proposal could leave the record companies short: The licensing rights would allow people to listen to any music they want any time. As Sony said, "it's obvious to anyone that follows the music business that the numbers Napster proposed on Tuesday do not make sense for a $40 billion industry." Both Mr. Parsons and Mr. Messier also say their companies won't talk with Napster about licensing proposals until the service stops offering pirated music.
Subscriptions as Lures
The record companies are also keen to offer their own versions of subscription music to counter the lure of Napster. Rather than selling single songs or albums through downloads, subscription services offer consumers the ability to get as much music as they want for a fixed monthly fee of $10 or $15. During the past year AOL and a joint venture of Vivendi and Sony had announced plans for such services, although neither revealed details like price or precisely how much music would be available. Music executives have been grappling with whether these services would include new music as soon as it's released. Their worry is that if it did, people wouldn't buy albums anymore.
Keen to show industry critics they're not ignoring the Internet, Vivendi and Sony struck last week's deal with Yahoo to make their subscription service more easily available. RealNetworks' deal with AOL, EMI and Bertelsmann means music of all three record companies will be potentially available to subscription services offered by other companies through a jointly owned venture called MusicNet. Bertelsmann hopes Napster will come back to life by striking a deal with MusicNet, although other music companies involved with MusicNet are skeptical. Hedging its bets, Bertelsmann is also creating a new online music company, BE Music, by merging CDnow with the company's music club.
Bertelsmann's own BMG unit has lately been more conciliatory toward Napster, now that Mr. Middelhoff has finally installed an executive to run the unit who shares his vision -- Rolf Schmidt-Holtz, former head of Bertelsmann's television division. BMG's previous chief executive, Mr. Zelnick, and its chairman, Michael Dornemann, resigned late last year, shortly after the Napster deal was announced, although their decision to leave had been made earlier. Disagreements over performance and compensation contributed to their departures.
Mr. Middelhoff says that, in selecting Mr. Schmidt-Holtz, he was eager to find somebody outside the music business who understands the Internet. "Always I'm hearing, 'It's the music industry, it's so special,' " he says. "I don't know why it's so special."
-- Cecilie Rohwedder contributed to this article.
Write to Martin Peers at martin.peers@wsj.com6 and William Boston at william.boston@wsj.com7 |
