Napster's keeper makes big Net bet

A $60 million wager on Napster falls flat, but the company is still up for the high-stakes online game.

Jim Hu Staff Writer, CNET News.com
Jim Hu
covers home broadband services and the Net's portal giants.
Jim Hu
10 min read
NEW YORK--Every afternoon, teenage girls crowd the sidewalk in front of MTV's studios, sending up lovesick screams that bounce off the towering glass and concrete of Times Square and across Broadway to the U.S. headquarters of German media powerhouse Bertelsmann.

The scene gives the 5,000 employees at those offices a daily reminder of the vicissitudes of the music industry: MTV, which began as an upstart in the overlooked music-video business 20 years ago, now has unprecedented power to make or break new music with its programming.

Today, the Internet offers the promise and peril of an MTV-like revolution--but this time Bertelsmann and its rivals in the music business are determined to harness the uprising.

The online threat has set off a flurry of unlikely deal-making among media companies, helping push the venerable Time Warner into the arms of America Online in an historic $127 billion acquisition this past January. It also inspired Bertelsmann about a year ago to hand a $60 million loan to Napster, the notorious file-swapping service charged by the record labels with helping people trade billions of copyrighted songs for free.

The deal gave the German record-label owner instant maverick status in the conservative music industry; it also emphasized the contradictions facing media companies forced to deal with the Net. But a year later, having doubled its original investment, Bertelsmann has reaped little from its gamble: Napster has been effectively shut down under court order; a planned relaunch has been postponed until sometime next year; and millions of former fans have switched to alternative services such as Kazaa, MusicCity and Grokster.

"Napster today is not Napster," Universal Music Group CEO Doug Morris said in October during a press luncheon. "You should refer to it in the past tense."

Bertelsmann declined to comment on issues related to Napster.

The company's high-risk investment reflects deeper dilemmas that are the subject of intense debate within most media companies today: How to best tame the Internet tiger without getting eaten?

Despite the collapse of the dot-com craze, many of the world's most venerable companies are betting heavily that consumers in the future will find most of their media and entertainment online.

Bertelsmann at a glance
CEO: Thomas Middelhoff
Headquarters: Gutersloh, Germany
Ownership: Private company divided among Bertelsmann Foundation (56.7 percent), Groupe Bruxelles Lambert (25.1 percent) and Mohn family (17.3 percent)
Employees: 82,162, in 56 countries of operation
2000-2001 revenue: $18 billion

I. Content
BMG Entertainment: Owns Arista Records, RCA, La Face Records. Stars include Christina Aguilera, Whitney Houston, Sarah McLachlan, the Dave Matthews Band, Toni Braxton.

Gruner + Jahr: Magazine publisher whose titles include Germany's Stern, Family Circle, Fast Company, YM, Inc. and Rosie.

Random House: Book publisher that owns Alfred A. Knopf, Doubleday and Pantheon. Signed authors include Toni Morrison, John Updike, John Grisham and Danielle Steel.

RTL: European broadcasting and production giant that owns 24 TV and 17 radio stations throughout the continent.

BertelsmannSpringer: Publisher of trade magazines and science-related literature. Publications are Europe based.

II. Services
Arvato: Media services group that offers book printing, distribution, information-technology services and CD manufacturing.

III. Direct Group
Book Clubs: Sells directly to readers through mail order. Operates in North America, Asia and Europe.

Bertelsmann E-Commerce Group: Spearheads Bertelsmann's Internet efforts, including its online-music foray. Combines all online direct selling properties including CDNow, Bertelsmann Online and a 50 percent stake in Barnes&Noble.com. Developing BeMusic, which will become Web hub for online music powered by Napster's technology and featuring direct sales through CDNow and music storage through Myplay.com. Expected to launch next year.
Source: Bertelsmann.com investor relations
AOL's groundbreaking acquisition of Time Warner was quickly followed by French media company Vivendi's acquisition of Universal, creating a new breed of conglomerate with tentacles in myriad overlapping businesses. These companies create music, films, magazines and TV shows and then deliver their products to people through a variety of outlets, such as broadcast networks, cable subscriptions and, more recently, the Internet.

But Bertelsmann, with $18 billion a year in revenues, has found surprisingly few avenues by which to enter the rapid consolidation of the industry. Its attempts to grow through acquisitions have been thwarted by international regulators and hampered by its status as a private company. Despite intentions to go public in three to four years, which would provide necessary capital for big acquisitions, IPO plans remain elusive given the slack state of the market.

"Bertelsmann doesn't compete in sheer scale with any of the megacorporations involved in the market here," said Tony Lock, an analyst at market research firm Bloor Research in London. "They're trying to find different ways to keep hold of market share but also trying to grow their business and grow their bottom line. They're trying to keep swimming with the big guys and move fast."

The art of the deal
Leading Bertelsmann through these turbulent times is its shoot-from-the-hip CEO, Thomas Middelhoff, whose penchant for bold strokes has sparked considerable controversy within the company.

Middelhoff has fans among analysts, some of whom see his strong medicine for Bertelsmann as courageous.

"He, more than any other CEO of a major media conglomerate, is speaking out about the music industry and taking an active role in the company's music initiatives, which is unusual," said Eric Scheirer, an analyst at Forrester Research.

Others, however, say Middelhoff's input stems primarily from a single, deeply influential experience in Internet investing acquired years ago: In 1994, while head of corporate development, he took a stake in AOL, investing $150 million for a 50 percent stake in AOL Europe and then an additional 5 percent stake in the company for $50 million.

The investment was prescient. In March, 2000, AOL agreed to repurchase Bertelsmann's stake in AOL Europe for between $6.75 billion and $8.25 billion. Despite pressure from regulators for the companies to divest, the deal was struck at the height of AOL's stock bubble and flooded Bertelsmann's coffers. The company now has $8 billion in cash.

Not surprisingly, the deal fueled Middelhoff's rocket shot into the executive suite and would overshadow his decision making once he became CEO in 1998.

Middelhoff "made one really great deal in his life, and that's when he bought AOL well and sold it well," said one source close to Bertelsmann. "It was well thought out, and his timing was smart. But I think he took that as a model of how you succeed in business."

Bertelsmann declined to make Middelhoff available for this story.

In a recent earnings release, however, the 48-year-old executive explained his vision of creating "an integrated media company that generates appealing content and fosters talent on the one hand and sustains an in-depth, trusting relationship with its customers, club members and subscribers on the other."

The world Middelhoff is trying to create underscores how much faith Bertelsmann has placed on the Internet to guide its future.

Bertelsmann today is organized into three divisions: a content group consisting of record label BMG Entertainment, publisher Random House, magazine publisher Gruner + Jahr, and European TV and radio broadcaster RTL Group; a services group made up of printing and publishing powerhouse Arvato and rights-management company Digital World Services; and a commerce division led by a recently created Bertelsmann E-Commerce Group.

Ideally, Bertelsmann would control the entire process of creating content, securing it and selling it to people on the Internet. That's not to say the company would abandon its already successful process of selling books and CDs. But the process, dubbed the "value chain" in marketing jargon, is something many media companies are trying to own.

"What we're doing here is part of a blueprint in creating this new delivery mechanism for a consumer relationship," Andreas Schmidt, CEO of the Bertelsmann E-Commerce Group, said in an interview in July about his division. "Physical distribution of media will continue but at the same time (will evolve) into a new consumer relationship, which is in a digital form."

Growing pains
Bertelsmann has suffered some key setbacks on the road to that goal. In May, European regulators effectively derailed a proposed merger between BMG and EMI Recorded Music, requiring major concessions from the companies in exchange for approval.

That union would have done much to bolster Bertelsmann's position in music, as the combined company would have leapfrogged Vivendi Universal to become the world's largest record-label owner.

Despite some bumps, Bertelsmann has closed several major deals recently, most notably an agreement last year that gave it a controlling stake in European TV and radio giant RTL Group, which now ranks as the company's largest division. Bertelsmann in turn gave up 25.1 percent of itself to complete the deal.

When it comes to the Internet, Bertelsmann has bet heavily on Napster. But its online plan is moving in many directions at once.

The company is a key partner in MusicNet, the music subscription service it controls with RealNetworks, AOL Time Warner and EMI Group.

Meanwhile, its e-commerce division created a company dubbed BeMusic that weaves together Bertelsmann's various music distributions divisions, including online retailer CDNow, storage locker Myplay.com, the BMG Direct record club and its Digital World Services rights-management service. Eventually, Napster may be included in the mix.

The company also is 50-50 partner with Barnes & Noble in Barnes&Noble.com, an online retailer of books, music CDs, videos and other products. The partnership has seen some recent successes, including taking market share from online retail powerhouse Amazon.com, according to a recent study.

The game plan has so far played well by the numbers: In September, the company reported that its net income in the last fiscal year increased by 44 percent to $868 million (968 million euros) on top of a 21 percent revenue increase to $18 billion.

Still, Bertelsmann has plenty of climbing to do. Like other big media companies, such as Walt Disney, Viacom and AOL Time Warner, Bertelsmann has felt the effects of a worsening economy exacerbated by the September terrorist attacks on the World Trade Center. It needs to find new ways to continue growing its revenue, particularly in its music division.

Revenues for BMG slipped 7.6 percent to $3.32 billion. Earnings excluding certain charges also fell into negative territory, swinging to a $4.48 million loss before interest, taxes, depreciation and amortization (EBITDA).

The poor results come after a year of instability within the division, sparked largely by the company's Napster investment--a decision enforced from the top down on unwilling executives within BMG.

Over the past year, the division suffered a major management exodus, lead by the departure of its former CEO Strauss Zelnick, a transition that was complicated by the unexpected death of Zelnick's successor, Rudi Gassner, shortly after.

A flurry of executives loyal to Zelnick resigned or were shown the door, including marketing head Kevin Conroy, who joined rival AOL Time Warner.

To fill the gaps, Bertelsmann in January 2001 named Rolf Schmidt-Holtz, a former journalist and TV programmer with no experience in the record industry, as head of BMG Entertainment to fill in for Gassner. People close to BMG said Schmidt-Holtz was viewed as a temporary leader until BMG could close its merger with EMI, whereupon the combined entity would be run by more experienced executives.

The Napster gamble
The moment when most of the turmoil for Bertelsmann began was Oct. 31, 2000. That day, the company announced it would lend about $60 million to controversial file-sharing service Napster, thus setting down a new course for the company. Middelhoff declared that Napster would secure licenses from the recording industry and launch a revamped service that respected copyrighted material.

In June, Napster signed an agreement to support the MusicNet subscription service. Then in September, Napster settled a lawsuit brought by music publishers. Napster was forced to pay $26 million in settlement fees and a $10 million upfront fee to license songs represented by the National Music Publishers Association, opening the door for it to sell copyrighted music. Executives close to Napster say the company has created a secure version of its service.

Despite such progress, Napster said last week that it has postponed the launch of the legal, paid version of its service until the first quarter of 2002.

Bertelsmann's Napster gamble now runs about $100 million. The original deal allows Bertelsmann to exercise warrants for equity once Napster launches a legal version. The media company also paid the bill in the publishers' deal and has pumped an additional $7 million to $12 million into the service, according to sources close to Napster and Bertelsmann.

"Bertelsmann needed to get into (the online-music game), and this was their entry point," said Mark Harrington, an equity analyst at JP Morgan in London. "I viewed it as a defensive play, and perhaps it was intended to make noise in the market."

The Napster investment was looked upon disdainfully by members of the recording industry. Many rivals criticized the deal, and Bertelsmann's subsequent publicity push surrounding Napster, as further proof of Middelhoff trying to ignite a media circus despite the company's participation in an ongoing record industry lawsuit against Napster.

Most damning, people point to Middelhoff's declaration that Napster would launch last July as proof that his promises are not golden. So far, the only company willing to use Napster's technology is Bertelsmann itself. And with the rise in Napster alternatives and the upcoming releases of MusicNet and Pressplay, both products of the record industry, Middelhoff's gamble appears to have backfired.

"It was a combination of not fully understanding copyright law and wanting to move quickly to take advantage of the perceived popularity of Napster," said one former Bertelsmann executive about Middelhoff's decision to invest in the file-swapping service. "The focus was on distribution, not copyright ownership."

Middelhoff has remained silent about the chances of striking licensing deals. To date, Napster's sole deal for distribution is with Bertelsmann-backed MusicNet. People close to Napster have characterized it as a licensing deal, and people close to the labels say the deal is limited to sharing technology.

"It's like they're launching new Coke," said one executive close to MusicNet. "Napster is going to offer something that's not as good as the classic."