The Music Industry Is Playing a Familiar Tune

A move is afoot to mate some big rivals, but it's not clear that approach will bear fruit.
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Music industry bigwigs seem to think a round of mergers can pull the industry out of its funk. But getting bigger may not be the answer.

Recent weeks have seen

Sony

(SNE) - Get Report

and

Bertelsmann

reach a nonbinding agreement to combine their recorded music businesses. Meanwhile, talks reportedly continue over

Time Warner's

(TWX)

efforts to combine its Warner Music unit with

EMI

.

So clearly, music executives believe the so-called economies of scale gained in mergers can help reverse the industry's steep slide. But given that the five biggest players already own at least three-quarters of the market, it's possible that such a strategy ignores the problem at the heart of the industry's well-chronicled decline. If an oligopoly isn't working out for its participants, why should bigger oligopolists fare any better?

Yet suggesting that the major labels' current market shares should suffice ignores the problems facing the industry, says Hilary Rosen, former CEO of the Recording Industry Association of America and now an analyst and commentator.

"It's not about market share," Rosen says. "It's about revenue and margin."

Tin Ear

By now, just about everyone has heard the discord in the recorded music business. Global music sales fell 17% from 1999 to 2002, and continued their slide this year, according the IFPI worldwide record industry trade group.

Meanwhile, the big players have continued to dominate the trade. Recent data indicate that the industry leaders -- Sony, Bertelsmann's BMG, Warner Music, EMI and

Vivendi Universal's

(V) - Get Report

Universal Music Group -- have an 83% share of the U.S. album market and a 75% of the worldwide market.

Record companies have already cut costs to adjust to declining revenue, says Rosen. By merging, they expect to cut them further. Manufacturing, distribution and sales costs, along with corporate overhead, all can benefit from economics of scale.

"What you're looking for in the mergers is, you've got significant infrastructure," says Rosen. "And you need enough releases going through the pipelines to justify the size of the infrastructure."

But certain hard costs -- signing artists, producing a record, marketing and promotion -- can't be cut further, Rosen thinks. "Those are the most expensive pieces of the business, and you don't save money by merging," she notes. What companies are likely to do after a merger, she says, is increase the number of profitable artists going through the pipelines -- in other words, get rid of less profitable releases.

"I think in all of these merger discussions," she continues, "you have to assume there are going to be significant roster cuts."

In that regard, the music business may find a lesson or two to be learned from the movie industry.

Keeping Up With the Goldwyns

As in the record business, movie studios move a limited number of creative works through a worldwide distribution system. And, as in the record business, a handful of companies claim a similarly large collective market share. Last year, the top five movie conglomerates shared around 70% of the box office.

Yet mergers-and-acquisition activity among film studios is a nonstory. No one in the movie industry seems to be itching for further consolidation.

Of course, the movie industry hasn't been hammered by piracy, offline and online, to the degree that the music business has in recent years. And the major record labels have many more discrete products to distribute than the film studios: hundreds or thousands of CD titles, vs. a few dozen movies.

Movies have multiple revenue streams, says Rosen: theatrical releases, television, pay-per-view and home video. But as piracy cuts into record sales, the music companies don't have alternative revenue streams: "It's hitting primary, secondary and tertiary markets," she says.

Though Rosen says that, as far as the music industry's problems go, the contrasts with the movies are more striking than any similarities, perhaps there is a lesson to be drawn from the movies. It's an old lesson, however.

Back in the 1950s, the movie industry was under attack from television. After decades of having cornered the market on moving-image entertainment, movie theaters had in TV a competitor that had the advantages of being not only more convenient for consumers, but also free. People didn't have to walk or drive to a movie house and buy a ticket to watch a story told to them on a screen; all they had to do was walk into the living room and turn on the TV. The competition was comparable to what record companies face from online file-sharing today. And it was legal, too.

How did the movie studios respond? In a variety of ways. They experimented with new formats: 3-D (a failure) and Cinemascope and other widescreen formats (which proved more successful). After shunning TV for a while, they learned they could make money by producing for the new medium.

Plus, they got small. Though the studios once operated in a universe that had so much demand for product that it made sense to keep vast numbers of actors and crew members on staff, they shed most of the infrastructure and overhead that had once been essential to the golden age of Hollywood.

Certainly, the record labels have already made cutbacks to deal with the new realities. And yet the "significant infrastructure" that Rosen refers to still doesn't have enough product, or enough profitable product, to make the system work. Perhaps the answer is a more radical pruning of what it means to be a record label.

After all, among the largest record companies, size does not appear to be a particular benefit. Universal Music Group has the largest market share of any of the five major labels, both in the U.S. and worldwide. Yet it's suffering along with its smaller compatriots. As Vivendi reported Friday, UMG's third-quarter sales declined 9% from the third quarter of 2002 on a constant-currency basis. In the first half of the year, UMG had an operating loss of 42 million euros, compared to an operating profit of 169 million euros in the first half of 2002.

To be sure, if one record company happened to have 90% of the market -- a Microsoftian feat -- it would undoubtedly turn a profit.

But maybe record labels are looking in the wrong direction. Maybe the solution isn't to get bigger, but to get smaller.