BMG at Loss After Rival’s Merger Stole Its Thunder

Bertelsmann Inc. Chairman Thomas Middelhoff has said he has a business strategy that would catapult the German media giant to the top of the global music industry.

But his designs appear to have been swept aside with the surprise announcement last week that Time Warner and EMI Group had cut a deal to merge their music operations--a move that would banish Bertelsmann to the bottom of the rankings.

Now, with his prospects of acquiring another company looking bleak, a frustrated Middelhoff lashed out Friday at his company’s executives in an internal memo obtained by The Times.

“We have always maintained that we are shooting for the No. 1 position,” said Middelhoff, warning that the company would never achieve that goal if its “executives sit back and wait to see which tactical move and strategic alliances the executive board develops in order to master the radical changes occurring in the communications marketplace.”

“Each and every one of you has to rise to this special challenge,” added Middelhoff. “Those who still haven’t understood that that time has come jeopardize both their existence and their position at Bertelsmann.”

Middelhoff’s pointed remarks follow months of corporate infighting at Bertelsmann Music Group that threatens to damage the company’s credibility in the creative community. A series of recent missteps has caused artists and executives to criticize the management style of BMG chief Strauss Zelnick, whom Bertelsmann officials once praised for streamlining the company’s U.S. division, spearheading its Internet strategy and restructuring its record club, and RCA and Windham Hill labels.

The only way Bertelsmann has a shot at getting to No. 1 now is if it buys Sony Music, but Sony is not for sale. And a merger between the two is unlikely because it would almost certainly require Bertelsmann to relinquish control of the combined operation to Sony’s superior music management team--something, analysts say, the Bertelsmann board would never do. (Sources say Middelhoff and Sony Corp. chief Noboyuki Idei met last week in Europe, but are far from reaching any deal.)

In his memo, Middelhoff conceded that Bertelsmann is now last on the list of the world’s music majors--where it ranks a distant fourth behind Seagram’s Universal Music Group, Warner EMI and Sony. Middelhoff said the company plans to bulk up in the future through “organic growth” by adding new labels and signing new recording artists.

None of that will matter if Middelhoff cannot convince Zelnick and Zelnick’s boss, Michael Dornemann, to stop alienating the record chiefs who recruited and develop the hit acts BMG already has under its roof.

Indeed, there is speculation that at least one of BMG’s most successful label heads, Zomba Group chief Clive Calder, is unhappy and could jump ship next year to Warner EMI Music. Zomba’s Jive Records label has sold tens of millions of albums by such pop stars as ‘N Sync, Britney Spears and the Backstreet Boys.

Zomba’s U.S. distribution deal with BMG runs out in June of 2001--about five months after the Warner-EMI merger should be completed. Zomba’s Calder, who tangled last year with Zelnick, is a longtime friend of Ken Berry, music chief of EMI and future chief operating officer of the combined Warner EMI operation. (EMI already distributes Zomba music to several territories outside the U.S.)

BMG’s troubles with Zomba began last fall when Calder attempted to steal a pop group from the BMG-owned RCA label and Zelnick decided that the corporation should file a lawsuit against Zomba. After a court rejected BMG’s attempt to stop Calder, Zelnick withdrew the suit and negotiated a one-year extension of Zomba’s distribution deal with BMG. Sources say Middelhoff played a role in convincing Calder to renew his BMG deal, but bad blood between Calder and Zelnick lingers on.

If Zomba leaves BMG for Warner EMI, the German conglomerate would lose a third of its 19% share of the U.S. music market. Warner EMI, on the other hand, would surge ahead of Universal Music Group to dominate the U.S. with around 30% of the market.

Calder is not the only record chief that BMG may soon lose. There is also speculation that embattled Arista Records founder Clive Davis could wind up starting a label for Warner EMI or Universal Music Group after his contract with BMG expires in June.

Davis has been fighting with BMG since November, when Zelnick informed him that the corporation intended to implement a succession plan by installing Antonio “L.A.” Reid as president of Arista, sources say. Davis, who earns a whopping $20 million annually in salary and bonuses, sees the move as a ploy to reduce his power at the label and ultimately push him out the door, sources said.

Davis, 66, launched Arista 25 years ago and has run the label autonomously with great success, contributing about a third of BMG’s market share with music by such acts as Carlos Santana, Aretha Franklin, Whitney Houston and Patti Smith. Over the past few months, those artists and other Arista performers have voiced their outrage over the prospect of Davis’ ouster.

Bertelsmann is not pleased that its back-room battles with Davis have spilled into the media, but the German conglomerate’s music managers appear to be buckling under the pressure.

BMG executives are now kicking around a face-saving solution to the problem in which the corporation would invest about $300 million in a new label for Davis after he exits Arista, sources say. BMG executives believe the corporation would be able to recoup its investment after Davis takes the label public, sources say. Middelhoff has yet to be apprised of the idea, sources added.

Under the tentative proposal, BMG would advance Davis about $100 million in start-up costs and offer him a $100 million line of credit plus the contracts of several top Arista artists worth about $100 million, sources say.

That’s about three times what it would cost to keep Davis in the driver’s seat at Arista for the next five years. The move has left competitors and analysts scratching their heads, wondering why BMG doesn’t just swallow its pride and give Davis what he wants: to continue running Arista.

It also raises questions about whether Zelnick, who got BMG into this mess in the first place, can help Middelhoff achieve his ambitious goals for the struggling music group. That topic and others, sources say, are likely to be discussed next week when Middelhoff flies in from Germany to meet with Davis to talk about his future at BMG.

If Middelhoff wants to transform BMG into the industry leader, he’s going to have to devote more time to outwitting his competitors and a lot less time to putting out fires set by his own management team.