Is the Music Store Over? The big CD retail chains may have only a few more years before the downloading craze buries them. They can survive, but only by becoming like no store you've seen before.
By Paul Keegan

(Business 2.0) – You can forgive the chaotic, run-down atmosphere when you walk into Tower Records on Broadway and West Fourth Street in Manhattan. You don't even mind all those SpongeBob action figures and Beatles lunch boxes--hey, the music industry's in a slump, and these guys are just trying to pay the rent. But when you pick up The Essential Bruce Springsteen, your temperature starts to rise. You should be ecstatic at the discovery of 12 new releases by the Boss, but instead you're furious: You can't buy them unless you shell out $25.99 for the entire three-CD set that includes 30 "career-spanning classics" that you already own from his other hit records. Why should you have to pay for all those songs twice?

You shove Bruce back into his display case and pick up The Ragpicker's Dream, by Mark Knopfler. It has one funny, tender tune that you love, called "Devil Baby"--but what about those other 16 songs? It'll cost you $23.99 to find out. How about the new Cypress Hill record? Norah Jones's second album? The latest from Pink, the Strokes, or Blink 182? Suddenly, everything seems like a crapshoot. Why do they keep insisting that you buy an entire CD when you can just go online and get only the tunes you really want from iTunes or Musicmatch for 99 cents each--or through Kazaa or Grokster for free? Fed up, you walk away without buying anything.

No wonder Tower Records and the other music-store chains are in a dizzying tailspin. Retail sales of recorded music dived from $13 billion in 1999--the year Napster launched--to an estimated $10.6 billion last year. The plunge in CD sales has hurt the entire music business, but no part of the industry has suffered more than the traditional retailers. Last year the 148-store Wherehouse chain filed for Chapter 11, and in mid-February, Tower Records followed suit. Musicland Group, the No. 2 music retailer, closed 260 of its 1,230 stores during the past year, and smaller chains like National Record Mart have simply disappeared.

To add to the merchants' misery, legal downloading has finally hit its stride. Steve Jobs hopes to sell 100 million iTunes downloads by April, and fearsome competitors like Dell, Microsoft, and Sony have announced online music stores of their own. Analysts project that in the next five years, 20 to 33 percent of music sales will shift from CDs to digital distribution, and Forrester Research concludes that eventually "CDs, DVDs, and any other forms of physical media will become obsolete." Whether that happens in 5, 10, or 20 years is anybody's guess--but the LP, you will recall, disappeared in the blink of an eye.

The music industry's belated embrace of digital distribution may restore some of the sales that the record labels lost to piracy, but it only further undermines the business model for brick-and-mortar CD outlets. For example, No. 1 retailer Trans World Entertainment, parent of FYE and new owner of Wherehouse, had $378 million tied up in inventory at the end of its most recent fiscal year and $155 million more in plants and equipment, most used to distribute those 4-inch plastic discs. Now it has to compete with online distributors that have essentially no physical inventory or shipping costs. More important, virtual stores can offer music by the song, while Trans World and its peers are stuck peddling a format that customers increasingly say they don't want. Retail consultant and consumer anthropologist Paco Underhill, author of Call of the Mall: The Author of "Why We Buy" on the Geography of Shopping, believes that half of the music stores now in existence will be gone within five years. "The merchants," he says bluntly, "are getting screwed six ways to Sunday."

The big retailers are maintaining a brave public face, insisting that they are, in fact, prepared for the future. A consortium of seven top chains--Best Buy, Borders, Hastings, Tower, Virgin, and Trans World's FYE and Wherehouse--is creating its own music downloading service, Echo, due to premiere later this year. In the meantime, Echo CEO Dan Hart says, despite "all the gloom and doom about the death of the traditional CD," the vast majority of consumers still buy their music on a disc. The consortium's 3,500 stores boast traffic and sales that no website can approach--2 billion customer visits and 350 million CDs sold during 2002.

Behind the confident talk, however, retailers are scrambling to move into the 21st century almost overnight. They are experimenting with new in-store technology, from Internet-connected kiosks to portable Wi-Fi devices that let you sample music as you roam the store. The chains' existing customer base buys them time, but as mall rents go up and CD sales keep falling, that grace period is running out. Within the next couple of years, they must answer a question that gets to the heart of their very existence: How can they persuade people to shut off their computers and go shopping in their stores?

When you ask music retail executives why they're hurting so badly, they'll rattle off a long list of reasons. Many chains grew too fast during the '90s CD boom and found themselves overextended when sales dried up. Discount merchants like Wal-Mart and Target are selling at rock-bottom prices simply to lure customers into their stores, where they can be sold higher-margin items. And consumers complain that the quality of the product has deteriorated while the prices remain high: Why should they risk $20 on a CD when they can get a $100 million action movie for the same price?

More than anything else, however, these executives point to piracy--not just through file-sharing programs like the old Napster and today's offspring, Kazaa and Grokster, but via the ripping and burning of CDs. The latter activity has reached such stratospheric levels that sales of blank discs are now actually higher than those of prerecorded CDs. "These technologies have allowed the flourishing of a piracy environment that has never been seen in this country before," says Eric Weisman, the CEO hired in August to turn Musicland around.

No one questions that piracy has eaten into profits. But all the attention paid to the moral and legal issues surrounding copyright protection has allowed the music labels to avoid taking responsibility for violating a cardinal principle of business: Give the customers what they want. When the LP was introduced 50 years ago, most people had a record player in their living room and maybe another in the kids' bedroom. Today, the typical American household has multiple sound reproduction devices, from Walkmans and boom boxes to car stereos, computers, and MP3 players. Why shouldn't people be able to buy music in a form that suits their modern lives--single songs delivered instantly and easily copied from one device to another? "The record labels haven't been able to understand this new business model and how it fits in with their existing model," says Kenneth Hertz, whose Beverly Hills law firm has represented musicians such as Alanis Morissette, No Doubt, and Beyoncé Knowles. The ironic result is that the music industry is struggling at a time when people are listening to more recorded music than at probably any other point in human history.

To stay in business, retailers have had to diversify wildly--not just into movies, computer games, and electronics, but also into clothing and toys--and now sell themselves as "entertainment centers." Walk into a Sam Goody store and you'll find portable CD players next to Homer Simpson dolls, as well as electric guitars and amplifiers. Trans World says fully 75 to 80 percent of its revenue came from music just a few years ago, but now that share is down to 60 to 65 percent. At Musicland, only 33 percent of revenue actually comes from music.

This trend puts an electronics retailer like Best Buy in an excellent position. It can slash prices on CDs to attract customers to higher-margin hardware, like CD and MP3 players. It can even bundle products with one or more of the downloading services popping up everywhere. Just as it sells Internet access with computers, Best Buy has partnered with the online service MusicNow, whose downloads play on more than 40 portable devices, including those made by Philips and Rio.

For dedicated music customers, however, discount superstores have a big downside. They are lousy environments in which to hang out and shop, with a selection limited to mass-market titles and a sales force that doesn't have a clue about music. (Increasingly, this is true of the big music chains as well.) That works to the advantage of small, independent record stores that offer in-store concerts, staffers who are true audiophiles, used LPs and tapes, and well-stocked shelves. Overall, the indies managed to hold sales flat last year, and the better ones have actually seen spikes of 15 to 20 percent, according to Don VanCleave of the Coalition of Independent Music Stores. But the indies face the same fundamental problem as the big music retail chains: They're stuck selling CDs.

At least the chains have the clout to join the digital movement (since they can't beat it) by creating their own downloading service. At press time, Hart was still working out the final details of pilot programs that will allow Echo to exploit its owners' greatest strength--the 2 billion customer visits the stores logged last year. Other virtual music stores may not have to pay rent like traditional retailers, Hart points out, but they also don't have the traffic that those rent checks buy.

Hart says that when an FYE mall customer arrives at the cash register with an Eminem CD, for example, the store could capture his credit card information and musical tastes by enrolling him in its free record club. This would entitle him to download two free Eminem tracks from an in-store kiosk or from the Echo website when he gets home. And if he decides to download a few cuts of Coldplay while he's online, he'll get a discount on the band's latest CD on his next trip back to the store--"synergizing the digital and the physical," Hart calls it.

Echo's kiosks might eventually allow customers to download as many tracks as they want and listen to them until they expire a couple of hours later. They could then buy full rights to the songs they liked best. "If these companies are going to have any future," Hart says, "they'll have to have this component of downloading music at home and in the stores."

The problems for music retailers are so deep, however, that some industry analysts fail to see how installing a few downloading kiosks will turn things around. "I think retailers understand the change that's taking place in their business," says Josh Bernoff, principal analyst at Forrester Research. "There's just not that much they can do. It's beginning to look very scary for them." The challenge is immense: How can the chains combine the customer service of the small indie stores, the latest digital technology, and a comfortable environment that will make music lovers want to hang out there? It can be done--but only if music stores are willing to rebuild themselves into something they've never tried to be before.

Paco Underhill lopes through the music section of a big-box retailer in Paramus, N.J., and stops near a skinny kid in a T-shirt emblazoned with the logo of the band Hatebreed.

"How do you know what's on that CD?"

"I don't, really," the kid replies.

"So why would you buy it here rather than someplace else?"

He holds up a Nirvana record from 1992--Incesticide--priced at $11.99. "I always come here for my CDs because they're cheap."

But isn't free better than cheap? Why doesn't he simply download it on Kazaa?

"I like to look at the stuff," he says, flipping through a rack of discs. "I like to have the packaging. I'll burn CDs if I want to put a few songs together, but for, like, an album, I'll go out and buy the album."

"There you go," Underhill says to a companion. More evidence to support his theory that record stores aren't simply places to buy music. To him, they're churches.

"Part of what he's doing is worshiping the music," Underhill explains. "Buying the CD is a way people show they care. They're buying it out of reverence rather than economic self-interest."

As Adam Smith spins in his grave, Underhill goes on to describe his concept for a retailer that connects with the deeper reasons people turn to music--catharsis, inspiration, comfort, and a connection to something larger than themselves. The stores that prove they share their customers' devotion, he says, will be the ones that lure them away from their computer screens.

Underhill has imagined with great specificity what such a store might look like (right). His inspiration comes from the comic-book clubs in Japan that allow customers to worship the art form they love while also providing a warm sense of community. His cathedral to music would be open to members of every faith--hip-hop, classical, heavy metal, jazz, R&B, dance, hard core, electronica, golden oldies, world music, you name it ... whatever makes people's hearts sing.

Customers would pay annual membership fees or purchase weekly or monthly passes that allow them to buy music in whatever form they choose, hang out with friends, and listen to live bands or mixes from a DJ. As a business model, it's similar to online subscription services--and the virtual stores, in fact, would become online extensions of the physical clubs.

As utopian as Underhill's vision might seem, it's remarkably similar to the thinking found in some of the new-store concepts at chains such as Virgin and Musicland. "We have to deliver a culture and environment that creates an ambience, a feel, an overall destination that allows us to market to our consumers," says Musicland's Weisman. "Music may bring people into our stores, but we have to create that ambience and sell an array of other products tied to it, and that's where technology, science, and art will meet."

If music retailers fail in that vision, it's hard to see what will halt their slide into irrelevance. But such transformations have taken place before. Starbucks, for example, turned the lowly coffee shop into a sanctuary for java junkies. Why can't some bright executive do the same with an experience as universally beloved as music?

Paul Keegan is a senior writer at Business 2.0.