Why Napster Won't Get Its Groove Back

Bertelsmann, sooner or later, will realize that even its $100 million investment isn't going make the service a winner again

By Jane Black

We in the media can't get enough of the perils of Napster. The endless twists and turns of the online music file-sharer's legal travails have an intoxicating element -- an underdog valiantly fighting an Establishment that just doesn't seem to understand the wave of changes unleashed by the digital revolution.

Last month, the tale took a strange turn when U.S. District Court Judge Marilyn Patel, who had sided consistently with the music industry in its suit against Napster, suddenly seemed to have a change of heart. She ruled that the Big Five record labels must prove that they -- and not the songwriters -- do indeed own digital copyrights. She also mandated that the labels demonstrate that they didn't collude to choke the distribution of digital music.

Is this Napster's revenge? Could its ongoing legal battle bring down the major labels? What a story that would be! Sadly, however, for Napster, this is probably the beginning of the end rather than the other way around. On Mar. 8, the company announced that it would lay off 10% of its staff.


  Napster isn't ever likely to regain its former glory. Sure, it still has a brand name, but that's about all: Its users have abandoned it for underground swapping services that have none of the restrictions on copyrighted music that Napster was forced to add in response to the recording industry's suits. It's time for everyone -- especially German media conglomerate Bertelsmann -- to concede as much.

Since October, 2000, Bertelsmann has ponied up about $100 million to sustain the ailing service, which at one time boasted 80 million users. Now, thanks to the recording industry's legal assault, Napster has crumbled to become just another struggling music upstart. When Bertelsmann first invested in Napster, it planned to use the service as an online distribution platform for its wealth of content, which includes television programming, books, and music.

Keeping Napster afloat probably will mean paying some hefty fines to the record labels. These could easily top $190 million. That's what MP3.com, now owned by Vivendi Universal, had to pay for the comparatively minor sin of streaming copyrighted music, rather than allowing users to download it, as Napster once did. Moreover, the media giant's support is indirectly funding Napster's case against the music labels, including Bertelsmann-owned BMG. If Napster wins the next round, it will be at the expense of one of Bertelsmann's most established business divisions.

In short, Bertelsmann's alliance with Napster is beginning to look like an example of throwing good money after bad.


  For the record, Bertelsmann maintains that it "remains committed to Napster in their efforts to bring to market a consumer-friendly, peer-to-peer, digital-music service that compensates artists and rights holders," though a spokeswoman declined to specify just how much of an investment that would entail. That depends entirely on Thomas Middelhoff, Bertelsmann's swashbuckling CEO, who company insiders say is Napster's leading advocate. Last December, many believed that Bertelsmann would abandon the alliance after Andreas Schmidt, the German giant's head of e-commerce and architect of the Napster deal, resigned to pursue "new entrepreneurial opportunities."

According to one insider, however, Schmidt left because he realized that the original $60 million investment in Napster could never pay off -- a fact that Middelhoff, 48, would not accept. Since then, Bertelsmann has ponied up $36 million more to help Napster pay its settlement with the National Music Publishers Assn., plus a reported $7 million to $12 million for operating costs (see BW Online, 10/26/01, "Bertlesmann Has Napster Stuck in Its Head"). "All it got them was a lot of hassle, anger, and wasted manpower -- not to mention $100 million in wasted money," says the source, who adds: "But for Middelhoff, it's personal." Napster declined to comment on the status of its relationship with Bertelsmann.

Why is Middelhoff so committed Napster? Perhaps his past successes investing in online ventures offer some clues. In 1994, as head of Bertelsmann's corporate development, he took a stake in AOL. For $150 million, he grabbed a 50% share of AOL Europe. Later, he acquired an additional 5% of AOL for a cool $50 million.


  Smart move. In March, 2000, Middelhoff got more than 35 times his original investment when Bertelsmann agreed to sell its stake back to AOL in a deal worth $6.75 billion to $8.25 billion -- $2.5 billion of which had to be cash. This January, AOL, its share price flagging, opted to pay an undisclosed amount of cash in the agreed range in two tranches. That money has helped see Bertelsmann through the sharp advertising downturn.

Still, one smart investment does not necessarily beget another. And though its $100 million Napster stake is lunch money for a media giant like Bertelsmann, Middelhoff can't afford to waste cash. While Bertelsmann reported profits of $844 million on sales of $17.4 billion in its last fiscal year, a closer look reveals problems at the operating level.

The TV and magazine units have been battered by the ad slump. And music label BMG slipped into the red -- due perhaps in part to the rise of file-sharing services like Napster. BMG's annual revenues for 2001 declined 7.6%, to $3.2 billion, from $3.5 billion the year before, and the division lost $5.2 million before taxes, depreciation, and amortization.


  Without $3 billion from sales of assets, Bertelsmann's bottom line last year was negative. "Middelhoff cannot afford to have another failure, but on the other hand, he can't afford to put more money into [Napster] either," says one insider. "Napster is no longer at the top of the agenda. It makes sense now to silently withdraw from the project."

Nor is it clear that a newly launched Napster would be the runaway success Middelhoff is counting on. When he made the investment, his goal was to parlay Napster's brand name into a legitimate distribution platform for Bertelsmann's content, especially BMG's music catalog. But he didn't anticipate the continued opposition even a contrite Napster would encounter from the labels' powerful lobby, the Recording Industry of America. Furthermore, the new Napster lacks the prime attraction that drew users to it in the first place: free music. A beta release in January to 20,000 members added a heavy layer of security that prevents the swapping of unauthorized music.

The sad truth is that digital-music aficionados have largely steered clear of legitimate music-subscription services such as MusicNet, which is backed by BMG as well as Warner Music and EMI, and the Sony-Universal venture, Pressplay. Instead, they've turned to free services such as KaZaA, Morpheus, and Grokster.


  Those services, too, face legal troubles, but that isn't stopping more than a billion files from being traded over their networks each month (see BW Online, 2/21/01, "Napster's Sons: Singing a Different Tune?") "With all the problems Napster faces, there's not much it can offer Bertelsmann now," says Eric Scheirer, a Boston-based digital-music expert. "Eighteen months ago, Napster had millions of users that could have been converted. Today, it has no users, no music, and an injunction hanging over its head."

Judge Patel's recent decision could prove to be a victory for Napster at the expense of the labels, including BMG. If the Big Five can't prove they own online copyrights, they can't ask the courts for damages to redress infringements. Such a ruling would also undermine any BMG strategy to move aggressively into online distribution since writers, not the labels, would own the copyrights and collect royalties.

The pro-Napster judgment also puts pressure on the labels to sign deals with the service to show that they're not hampering competition. Yet, despite long-running negotiations, Napster hasn't signed a single pact. With licenses in hand, it would finally be able to launch its new legitimate service -- one that had been scheduled for release at the end of March. Napster CEO Konrad Hilbers has said he won't relaunch the service until he settles with all or most of the Big Five labels.


  Any launch may be just too late, however. After years of legal battles, the file-sharing service has no real advantage over MusicNet and Pressplay, which are themselves struggling to persuade consumers to pay for music online. Nor is there any certainty that Napster will execute its service any better than its well-funded rivals are.

"Napster has never provided any proof that it's more than a small garage company that happened to be in the right place at the right time," says Scheirer. To warrant Bertelsmann's continued support, it'll likely have to do better than that.

Black covers digital music for BusinessWeek Online. BusinessWeek Frankfurt bureau chief Jack Ewing also contributed to this article.

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