Sold on a Digital Music Dream

An online joint venture could make it come true for Bertelsmann

Bertelsmann CEO Thomas Middelhoff is known as a demon networker, and he was in high gear as he showed Napster Inc. CEO Hank Barry around the World Economic Forum in Davos, Switzerland, last January. The German media giant had lent tiny Napster Inc. $60 million to remake itself from a venue for swapping stolen music tracks into a real business. In Davos, Middelhoff was trying to help Barry build an image as online visionary rather than copyright thief. "We introduced him to everybody," recalls Andreas Schmidt, chief executive and president of Bertelsmann's eCommerce group.

Music industry heavyweights like Vivendi Universal CEO Jean-Marie Messier weren't impressed enough to put aside their hostility to Napster and use it as an industrywide platform to sell music online. So now Middelhoff is hedging his bets. On Apr. 2, Bertelsmann, AOL Time Warner Inc., and London-based EMI Group announced they are teaming up with RealNetworks Inc. on a new online venture called MusicNet. The deal is Middelhoff's latest gambit to ensure that Bertelsmann will play a big role in the digital music business--even if Napster doesn't make it.

PLATFORM PROSPECTS. MusicNet is designed to be a digital music wholesaler. It will act as an intermediary between recording companies and online retailers, providing technology that allows fans to listen to music tracks over the Internet or download songs they can replay and keep. Most important, MusicNet will provide technology allowing recording companies to protect their copyrights and collect royalties. "MusicNet turns into a black box for companies like us that want to offer music services but don't want to have to build all that," says Barry M. Schuler, chairman and CEO of AOL, which plans to use MusicNet as the basis for its own music subscription service.

Middelhoff's dream of making Napster the file-sharing platform for Bertelsmann's whole range of digital products, from music to videos and books, is still alive. But the MusicNet deal broadens Bertelsmann's digital distribution base. Bertelsmann will own 20% of MusicNet, the same stake as the other recording companies. So Bertelsmann can be sure its music catalog will also be sold on AOL and any other subscription services based on MusicNet. Meanwhile, eCommerce chief Schmidt is making plans for an alternative consumer service called Be Music, which will use MusicNet to make Bertelsmann music available to customers on PCs, mobile phones, and other devices. "It's a different approach," Schmidt shrugs.

Indeed, if MusicNet works as planned, it could marginalize Napster, reducing it from the world's biggest online music site to a bit player. Bertelsmann's BMG Entertainment, Warner Music Group, and EMI will provide MusicNet with their vast catalogs, accounting for more than 50% of the music market and including artists from Bjork to Madonna. With that kind of critical mass, other record companies will feel pressure to distribute their catalogs via MusicNet. That in turn could push the fragmented music industry toward some kind of technical standard for music sales on the Internet.

Napster isn't down for the count yet. It, too, can buy music from MusicNet--provided it guarantees copyright protection. That's a big if, because tracking copyrights is devilishly complicated. Napster will still lack songs belonging to Sony Music Entertainment Inc. or Universal Music Group, who remain staunch adversaries. But if it can overcome the huge technical hurdles, Napster could have enough music from Warner, Bertelsmann, and EMI to convert at least some of its 72 million registered users to paying subscribers. "That's more than enough to build a viable business," says Mark Mulligan, London-based analyst for Jupiter Media Metrix Inc.

Still, there are big obstacles before Bertelsmann can use Napster to rake in online music riches. Napster is staggering under the burden of a court order to purge its system of copyrighted material. "That's the tough part," concedes Schmidt. AOL and EMI may now be more willing to join Bertelsmann in settling the legal dispute. But Sony and Universal still have every reason to make Napster's life as difficult as possible. They have their own joint online venture, Duet, which will be launched shortly. Hassling Napster helps them buy time.

Surely many Napster users will bolt to outlaw services if they have to start paying. Even if Napster can get one quarter to pay an average of $5 a month, though, it can generate more than $1 billion a year in revenue. Middelhoff hopes to end the legal challenges, then exercise an option to take a 58% stake and control what is still the media industry's most powerful online draw.

There are also formidable organizational challenges. Record labels are still in the process of converting their catalogs to digital form, a monumental task. In the process they're struggling to untangle who holds rights to different recordings. The confusion has bedeviled San Diego-based Inc., which has been trying to sell access to recordings from the major labels online since settling its own legal dispute with them last year. "These companies are wrestling with gigantic pools of unorganized data," says Michael L. Robertson,'s CEO. "We are still not able to offer a working system."

Napster faces an even more daunting logistical nightmare. It must filter out millions of copyrighted songs, which will slow down the system. Yet it must also remain as easy to use as it has been. "Napster sets the gold standard," says Antonella Mei-Pochtler, senior vice-president at Boston Consulting Group who has advised Bertelsmann. Napster aims to retain its unique appeal with proprietary technology that will let subscribers swap songs once they've been purchased via MusicNet. Napster is working furiously to perfect the technology so it can convince record companies that only paid- up subscribers will be allowed to swap songs.

Many in the music industry are still hoping that Napster will die a slow death. Yet none has found an alternative with such powerful popular appeal. Plenty is at stake: Few people expect digital downloads to replace store purchases anytime soon. Digital sales will account for only 6% of the European music market by 2006, according to Jupiter MMXI. Most music sales over the Internet will still be CDs ordered from e-tailers like Amazon Inc. and sent through the mail. But traditional music sales are nearly stagnant. The Internet offers a new avenue for growth by helping labels find a profitable market for obscure or niche recordings that will never get space on a store shelf. "The music business will be transformed by this long-term," says AOL's Schuler. If MusicNet's technology clears up the licensing confusion so that online retailers can be sure they are selling products with a clear title, it will be a major step forward--for the studios and, if it's lucky, for Napster.

By Jack Ewing in Barcelona, with Amy Borrus in Washington, Arlene Weintraub in Los Angeles, and Jay Greene in Seattle

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