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In the key of E

Can music stores hold their own in today’s multichannel world?

By Ed Christman

The two largest music retail specialty chains had their best years ever in 1999, but you would never know it by looking at their stock prices.

Shares of the 1,350-unit Musicland Stores Corp., Minnetonka, Minn., closed Feb. 25 at $6.93, slightly less than one-third of the historical high of $23.37 it reached in December 1993. The 967-unit, Albany, N.Y.-based Trans World Entertainment Corp. closed at $10.69, slightly more than one-third of its historical high of $30, which it hit in July 1998.

Despite the record earnings posted by both chains, Wall Street investors clearly are betting that record stores, the dominant distribution channel for music, soon will be replaced by sales on the Internet.

But that is outright wrong, at least for the next five years, say music industry executives; beyond that, they say, it's misguided at best.

"Obviously, there is a major disconnect between public marketplace valuations and the performance of the business," said Eric Weisman, president of Coral Springs, Fla.-based Alliance Entertainment Corp., one of the largest U.S. music wholesalers.

For the year ended December 1999, Musicland, operator of Sam Goody and Media Play, recorded the strongest performance in its history, posting a net income of $58.4 million, or $1.60 per share on a diluted basis, on sales of $1.9 billion.

Trans World posted net income of $61.4 million, or $1.15 a share on a diluted basis, on sales of $1.36 billion in the year ended Jan. 30, 2000, its second record-breaking year in a row. Trans World operates mall stores under the banners Record Town, Saturday Matinee, Camelot, The Wall and F.Y.E.

Musicland and Trans World weren't the only music merchants turning in strong performances in 1999. Tower Records/Video/Books, Wherehouse Entertainment, HMV, the Virgin Entertainment Group and Hastings Entertainment also posted good-to-decent years, according to the major music manufacturers.

"By any measure, brick-and-mortar is healthy," said Jim Urie, president of Universal Music & Video Distribution, the largest music manufacturer, with a 1999 market share of about 26%. "Store growth is good; it is the right combination of cautious and aggressive."

He added that the management teams running music retailers "are the best they've been in my time in the industry."

Price war
That wasn't always so. There was upheaval in the sector between 1994 and 1997 caused by a price war and overbuilding. The problems began in the early 1990s when several established retailers, including Circuit City, Borders Books, Barnes & Noble and Blockbuster Entertainment, added music to their offerings, joining Best Buy, which had added music in 1989. By 1994, the music sector was suffering from overbuilding, and Best Buy and Circuit City began going at one another using music as a loss leader.

During the next three years, about 10 chains filed for bankruptcy, including Torrance, Calif.-based Wherehouse Entertainment; Milford, Mass.-based Strawberries; and Canton, Ohio-based Camelot Music. Others like W.H. Smith and Blockbuster decided to divest their music holdings, and Musicland almost succumbed to Chapter 11 before a restructuring and store closings achieved a return to health. Trans World also was forced to restructure, closing some 200 stores.

Initially, the stock market responded to the comeback of the music sector by rewarding the publicly traded music chains. But by fall 1998, with a rapidly growing CDnow making a name for itself and Amazon.com adding music to its offerings, investors began transferring their money from music specialty chains to online merchants, depressing the stock prices of the four publicly traded music specialty chains: Musicland, Trans World, Hastings Entertainment and National Record Mart.

But while many investors have been impressed by the rapid growth of the two online merchants — New York City-based CDnow generated 1999 revenues of about $150 million, while Seattle-based Amazon nearly hit the $200 million mark in music sales last year on total revenue of $1.6 billion — retailers say it's easy to grow a business if you are willing to lose money on each sale. They point out that neither online merchant has a profitable business model.

"If you can't make a profit with a billion dollars in sales, how much revenue do you need to make a profit?" mused one retail executive, who asked to remain anonymous.

It is also significant that despite all the advertising the music e-tailers took out during the holiday season, they did little damage to the brick-and-mortar stores, observed Tony Alvarez, chairman and CEO of 540-unit Wherehouse Entertainment.

Jupiter Communications, a New York City-based consulting firm that follows Internet sales, issued a survey last August stating that 94% of 1999 online music sales would be cannibalized from other distribution channels. But record label executives and music merchants point out that for the second year in a row album sales in their stores were up by 6%.

Some executives wonder whether, instead of cannibalizing sales from traditional retailers, online sales may be taking business from the record clubs, the direct marketing arms of the music manufacturers. Both online music sales and record clubs predominantly sell catalog, or older, albums.

In 1999, Jupiter estimated that online music sales totaled about $325 million of the industry's total business of $13.7 billion, and predicts that sales through the Internet will grow to $2.56 billion by 2003. Most of those sales will be packaged goods — CDs, cassettes or possibly DVD audio.

While companies like Amazon, CDnow and CDuniverse were gearing up to do business on the Internet in 1995 and 1996, critics say, the record chains were missing the boat. But music merchants were well aware of the possibilities of the Internet; as far back as 1992 Musicland had a "store" in Prodigy's online mall, and Tower Records also was early to the online party as well, starting its online store in 1996. But during the price wars of 1995 and 1996, music retailers were too busy trying to avoid Chapter 11 to begin preparing a new and totally different business model.

Click-and-brick strategy
In the last year, most major chains have opened up online stores and are moving to embrace a click-and-brick strategy. But that hasn't quieted their critics, who point out that, with the exception of Tower, each of the brick-and-mortar-hosted online stores has annual sales under $1 million.

For their part, music merchants say the only way now to drive online sales appears to be through spending tens of millions of dollars on advertising. But they point out that Wall Street would not be too forgiving if, in an effort to build online sales, chains started to lose hundreds of millions dollars a quarter like Amazon.

The merchants say they are follow ing the appropriate strategy by using their brick-and-mortar stores to drive customers to their online sites.

"Those [music retailers] that are moving away from being just brick-and-mortar to being click-and-mortar are the ones that are most likely to thrive in the new environment," said Pete Jones, president of BMG Distribution, which last year was the third-largest music company.

In addition to building online stores, a number of digital suppliers are peddling kiosk concepts that will allow for in-store manufacturing of CDs, which would give even small stores the ability to offer a deep catalog selection and compete with the superstore players like Tower, Media Play and Virgin.

But there is another, even greater, threat to music stores that comes via the Internet, according to Wall Street investors and Internet proponents: The sale of music via digital downloads.

At the moment the new technology is plagued by music piracy. It's also crying out for upgrades to allow consumers to receive speedier, broadband transmissions. This past summer, David Bowie issued an album titled "Hours," which was offered exclusively by download for a two-week period prior to going on sale in stores. But only 989 copies were sold this way; customers complained that the album lived up to its name, because it took literally four hours to download.

Some Internet music buffs say downloaded music should be free, and that recording artists and labels should figure out some other way to make money. Fat chance: Over the next few years, the music industry will be building the infrastructure for a digital download market that will allow it to sell music securely over the Internet, and make money.

By 2003, Jupiter expects digital downloads to account for $150 million in sales. Alliance's Weisman predicts it will take a little longer. Even though the entire industry is gearing up for digital distribution over the Internet, "the realization of that digital market on any practical basis is probably 10 years away."

But in the meantime, record labels have begun competing with music retailers by setting up their own sites to sell music directly to consumers. Every major label has put up a company Web site that, in addition to giving information on artists and music, includes an online store. But since most consumers don't know what record labels their favorite record artists are on, this initiative has met with absolutely no success.

The labels soon realized that, to overcome the problem of consumer confusion, they needed a common site to sell music from all labels. That prompted Warner Music Group and Sony Music Entertainment to launch, through their jointly owned Columbia House company, an online store called Total-E. Meanwhile, BMG and Universal got together to form an online store called Get Music.

But by the middle of last year, it was becoming clear that both of those efforts were failing, forcing Warner and Sony to agree to merge their Columbia House unit with CDnow, and the latter pair to relaunch Get Music in March. (The CdNow/Columbia House merger later fell through in mid-March.)

Despite these efforts to sell music directly to the consumer, record company executives acknowledge that there still will be a large role for retail brands in promoting and selling albums, whether they be Tower Records, Musicland's Sam Goody, Trans World's Coconuts, or CdNow and Amazon.

But the music merchants are upset about their suppliers getting into competition with them.

"I think I am as confused as everybody else in the industry as to what is going to happen with the Internet," admitted Terry Woodward, president of Owensboro, Ky.-based WaxWorks, which operates the 115-store Disc Jockey chain.

"But my concern is not so much what is going to happen with the consumer on the Internet but what is going to happen with the record companies; as they start competing with us, how are they going to treat us? Will we have a level playing field?"

Retailers loudly cried foul in early February, when the National Association of Recording Merchandisers (NARM) filed a lawsuit against Sony Music Entertainment, seeking to enjoin the labels from placing cards inside CDs that advertise their online sites, and from putting hyperlinks to those Web sites in digital products like enhanced CDs. While NARM has filed suit against only Sony, it says that if it wins, it will use the suit as a guideline to settle the issue with the other majors.

Merchants say they are just seeking fairness. If the labels want to compete with them, they should use their own assets to attract customers, instead of doing their advertising on product inside record stores.

For the foreseeable future, the labels are going to depend on retailers, noted Bob Higgins, chairman and CEO of Trans World.

"It will be a number of years — maybe many, maybe never — before the labels will have the ability to break an artist through the Internet without retail's in-store playing, merchandising and suggestive selling," he said.

But the majors are so busy looking at the Internet as a way to cut out retail that they are misusing the medium's true opportunities, he added. The Internet presents a way for merchants to compile a database on each customer's buying preferences.

Currently, merchants and labels are wrangling over who would get the customer information when music is downloaded digitally. While a user might be using a retailer's Web site to find music, the act of downloading it automatically transfers him to a record company site. Record company executives see buyer information as a potential gold mine, but merchants say they will never agree to labels getting the data via their sites.

Because of the competition from suppliers, many merchants are trying to diversify their product offering and reduce their dependence on music sales. Executives at 181-unit National Record Mart, Pittsburgh, and Disc Jockey both say they are studying what other product lines they can bring into their stores.

Other merchants, including the 114-unit Tower and the 130-store Amarillo, Texas-based Hastings Entertainment, long ago diversified into other home-entertainment products, but even they say they are seeking to reduce further their dependence on music.

Music sales at Boston-based Newbury Comics now account for just 75% of the 20-store chain's revenues, according to Mike Dreese, its CEO.

"Why should we invest in music retail with the major labels so obnoxiously going after our customers?" he asked.

FTC oversight
As though music retailers didn't have enough to worry about already, another threat looms on the horizon. For the last three years, the Federal Trade Commission (FTC) has been investigating the labels' minimum-advertised-pricing (MAP) policies. MAP was instrumental in ending a price war from 1994 to 1996 that had wreaked havoc: Retailers couldn't pay bills and were cutting way back on inventory, hurting the labels' profitable catalog business. Merchants also were not supporting untested new artists, which are often called the lifeblood of the industry.

Sources say the FTC is about to rule against the majors' MAP policies. Already, two of the big labels, Sony and Warner, were said at press time to have settled with the FTC, agreeing either to eliminate MAP or to greatly reduce the parameters of their policies.

With the elimination of MAP, some fear an outbreak of another price war. But music merchants point out that the other two ingredients caus ing the fallout in the last industry downsizing from 1994 to 1997 — too many stores and massive debt — are not present this time.

Now, music retailers are in much better financial health. Moreover, they point out the Internet has extremely low pricing that so far hasn't hurt brick-and-mortar pricing.

Not only is the music segment not overstored, a survey of merchants shows that most are slowing down growth to concentrate on improving existing store operations. John Marmaduke, president of Hastings, a publicly traded music merchant, says his chain has reduced its store-opening rate for the coming year, and instead has accelerated its remodeling programming. Similarly, Woodward of WaxWorks says he will refurbish and/or expand 10 to 15 stores this year, and will be very selective about locations for new stores.

In Pittsburgh, Bill Teitelbaum, chairman of National Record Mart, says he has pulled back from the chain's aggressive growth pattern of the past two years, in which it added about 40 outlets through new stores and acquisitions. Instead it is concentrating on improving performance in existing stores. The main reason for the slowdown, he said, is that Wall Street is undervaluing his company's stock, and is not recognizing any investment he makes in the operation. On Feb. 25, the stock closed at $3.50, giving National Record Mart a market capitalization of $17.5 million. At that price, the chain's 181 stores are valued at about $97,000 each, while a new store costs about $500,000 for construction alone.

"Why should I invest $500,000 in a new store if the market is going to immediately value it at about $100,000?" he asked. "It doesn't make any sense to open a store if the market refuses to recognize the investment."

But Universal's Urie says that eventually the stock market will begin to recognize the strong performance of music merchants.

"As the click-and-mortar strategy of the industry becomes more self-evident, Wall Street will begin to reward the retailers for the excellent jobs that they have done in recent years."