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Music Industry Braces for a Shift

by Laura M. Holson and Geraldine Fabrikant
New York Times

The resignation last week of one of the music industry's most powerful figures, Thomas D. Mottola, the chairman and chief executive of Sony Music Entertainment, and his subsequent replacement by an outsider, Andrew Lack, a top NBC executive, has brought to the surface a growing sense of fear within the industry. The record business is bracing for a seismic shift and is increasingly reconciled to the fact that the current priorities of senior executives are outmoded.

What the Lack appointment underscores, analysts and industry executives agree, is the notion that the business is in such shaky condition that only an executive schooled outside the industry can come up with the radical approach that may be needed. In the last two years, the industry's basic business structure – selling music to stores – has taken a blow. The industry is now selling 100 million fewer CD's and cassettes than it did in 2000. According to Nielsen SoundScan, which tracks album sales, 681 million were sold in 2002, down from 785 million in 2000. At the same time, music-swapping on the Internet, perceived as a major threat, continues to grow.

The industry's immediate problem is that although costs must be cut, the biggest costs of all – talent and marketing – are the toughest to rein in. And although many analysts and industry executives say they believe that further global consolidation is necessary – perhaps trimming the number of major recording companies to three from five – those financial benefits can go only so far.

To some extent, mergers can help companies reduce overhead, which amounts to about a third of expenses, said Michael Nathanson, a music analyst at Sanford C. Bernstein in New York. But he points out that in the music industry, as in other entertainment businesses, mergers will not put the lid on the basic impulse of entertainment executives to bid against one another for talent.

The risk is that there will always be one profligate spender who starts a bidding war for artists, he noted. Talent and marketing costs are roughly 36 percent of overall budgets.

"The business model doesn't work anymore," Mr. Nathanson said. "There is going to be more pain before it gets better."

Companies also need to tap into new sources of revenue. They have already begun eyeing the money artists earn from concerts, sponsorships and the sale of merchandise, revenue that artists have so far kept for themselves. But most important, companies have to be more responsive to consumers, these analysts say, whether by making authorized copies of music more accessible online or even by lowering the price of CD's, a prospect that is being heavily debated in the industry right now.

Most experts agree that companies need to focus in the near term on cutting costs. Bruce Greenwald, a professor of finance at Columbia Business School who has studied the media industry, said that the music business had always been difficult to manage because of the amount of money paid to develop and market artists.

"Whenever there has been a drop in revenue, the industry has faced problems because it cannot control its costs," he said.

Not surprisingly, operating income at some of the major music companies has dropped this past year. Sony's music business, for instance, lost $132 million in the first six months of its fiscal year, largely because of higher artist costs. At the Universal Music Group, a division of Vivendi Universal, operating income dropped 89 percent in the third quarter, also from marketing and development costs, although executives there said they expected a bonanza after holiday profits are tallied in the fourth quarter.

But it is more art than science to figure out just how profitable the music divisions are. Some include highly profitable DVD manufacturing or sales in their music divisions' financial results, a practice that can mask losses. And Universal, Mr. Nathanson said, is still benefiting from cost savings achieved in its 1998 acquisition of Polygram.

Still, all the music companies have begun to trim where they can. The Warner Music Group, a division of AOL Time Warner, has cut 1,000 jobs in the past two years, a spokeswoman said, consolidated its back-office operations and trimmed its roster of artists. (She said the division was profitable.) RCA, a subsidiary of the Bertelsmann Music Group, announced 50 layoffs last week. And some music industry executives who are renegotiating their contracts are being asked to take as much as a 40 percent pay cut, a notion that was unheard of two years ago.

But cutting in-house costs is not enough, Professor Greenwald said. The revenue lost to music-swapping on the Internet is a long-term issue, and profitability will return only when costs have been adjusted commensurately, he said. Instead, he and others said, they believe that the industry has to rethink costs in almost every area – from the millions of dollars paid to retailers to the money paid to the independent promoters who push songs to radio stations' programmers. They even, perhaps, should sign fewer artists. "The revenues today can't support such a broad number of releases," said Michael Wolff, a media specialist at McKinsey & Company. "We are likely to see the big recording companies focus their bets more."

But most important, one veteran music executive said, is that the industry come to a decision to lower the cost of CD's to the consumer, a highly charged proposal within music companies these days. "Now if you buy a soundtrack," the executive said, "you pay more for a soundtrack to a film than you pay for the DVD of that film. It is completely crazy. A soundtrack has to be less expensive so that it is at the same price point or lower than the DVD's."

Hilary Rosen, chief executive of the Recording Industry Association of America, which represents the interests of recording companies, cautioned that lowering the price of CD's would not solve the industry's problems and that it would serve only to reduce revenue even further. The problems need to be tackled in other ways, she said, by communicating better with music buyers.

Music companies have usually worked to establish relationships with retailers, not consumers.

"There are several opportunities for us to be talking to consumers," Ms. Rosen said. "Not about music value, but what we have to offer."

For example, she said, the industry needs to promote the joy of CD collection and to revive the value of owning a physical object. Also, she said, the industry must try to consider how to produce music that takes advantage of increasing sales of surround-sound systems.

She also said that consumers must be made more aware of the music that the companies are already offering on the Internet.

In the end, the industry may turn to mergers as a fix anyway. Mr. Nathanson, of Sanford C. Bernstein, suggested that London-based EMI, the smallest of the major music companies and one that has already explored a merger with the Warner Music Group, is a likely target.

But Professor Greenwald does not agree that mergers will add much value. "In my opinion mergers will not do that much because there are no obvious economies of scale in the music industry, and there is no evidence that the surviving companies will be any good at keeping down artists' acquisition costs," he said.

In recent months, recording companies have made a series of new deals with artists – shorter three-record contracts, as well as revenue-sharing agreements – to bring down costs. But lawyers who represent artists say they fear that these deals are just a ploy by the recording companies to take more money out of artists' pockets and stuff into their own.

"Nothing is going to change," said Donald Engel, the longtime entertainment lawyer who represented the Dixie Chicks in their contract dispute with Sony. "They will just bargain harder."