(FORTUNE Magazine) – It was a party that gossip columnist Liz Smith called "a love-fest, an intimate spectacular." Kid Rock arrived in a silver top hat with Atlantic Records founder Ahmet Ertegun. Sex in the City star Kim Cattrall came in a black Geoffrey Beene dress that Smith observed "might pop apart with one deep breath." Sharon Osbourne, wife of Ozzy, showed up with her MTV reality-hit co-stars, Kelly and Jack.

Their host was Clive Davis, the 69-year-old record-company impresario who launched the careers of such singers as Janis Joplin, Whitney Houston, and Alicia Keys. Each year, when the music industry gathers in New York or Los Angeles for the Grammy Awards, Davis throws the week's most exclusive party, a celebrity-studded advertisement for himself. On this late-February evening Davis was also celebrating a milestone in his four-decade career. Three months earlier BMG, the music division of Bertelsmann, the privately held $17.3-billion-a-year German media conglomerate, had named him CEO of its RCA Music Group.

It was perfectly fitting, then, that Davis's party in the ballroom of Manhattan's Regent Wall Street hotel became a showcase for artists from BMG's labels, which include RCA, Arista, and Jive. Justin Timberlake had been booked to fire up the crowd with his hit single "Cry Me a River." Aretha Franklin was waiting in the wings to belt out her classic "Think" with Alicia Keys on piano. Rod Stewart was set to croon "These Foolish Things" from his platinum album It Had to Be You: The Great American Songbook.

But before Davis introduced those entertainers, he paid homage to BMG chairman Rolf Schmidt-Holtz, a portly, mustachioed German who sat near the stage surrounded by celebrities like Carly Simon, Danielle Steele, and Sean "P. Diddy" Combs. "The company in Germany has always stood behind me," Davis said. "I'm very indebted to Bertelsmann. I am very indebted to the worldwide chairman of the BMG Music Group, Rolf Schmidt-Holtz. Thank you, Bertelsmann."

The guests exchanged knowing glances. Nobody had forgotten how ugly things had become three years ago when BMG--the smallest of the Big Five record companies, which include Universal, Sony, EMI, and Warner Music and together control 71% of the world market--forced Davis out as head of Arista. At the time Davis enlisted Arista stars like Whitney Houston and Carlos Santana to publicly bemoan his ouster. Meanwhile BMG executives told the press that Davis had run the label as if it were a private fiefdom, refusing to rein in spending or provide a succession plan. Why, then, was the company welcoming Davis back?

To make sense of this, you have to understand Rolf Schmidt-Holtz's plans for BMG. A former TV executive with no music experience, Schmidt-Holtz took over the $2.6-billion-a-year music division of Bertelsmann two years ago. He has cut costs aggressively, laying off about a fifth of the workforce. He has abandoned most of the division's once-sacrosanct Internet ventures. He has told his remaining executives to focus instead on compact discs--specifically, on developing global superstars who can sell millions of CDs at a time when U.S. CD sales are down 8.9%, according to the Recording Industry Association of America. That is where he believes Clive Davis, who has a legendary ear for a hit song, could be of assistance. "I'll tell you, bringing back Clive Davis to BMG after all that Clive Davis history, it wasn't easy," says Schmidt-Holtz. "I'm so proud we were able to achieve it."

In the short run, the strategy has paid off. BMG lifted its share of the market for newly released albums in the U.S. to 17.4% in 2002 from 17.0% the year before, beating out larger competitors with hits like teen rocker Avril Lavigne's Let Go, which sold 12 million copies. Bertelsmann is expected to announce this month that BMG earned profits of $120 million last year, the first time its labels have made money since 1999. EMI and Warner have launched cost-cutting drives too. The added discipline has made a difference at the formerly free-spending firms: Though revenues for all but one of the Big Five were flat or down last year (see chart), Ebitda and cash flow for the cost cutters were up.

Does that mean the beleaguered record industry is finally coming to its senses? Not exactly. As online piracy continues unabated, the industry's primary mode of business--selling CDs--is eroding fast. Sales projections are dire (see chart). None of the five majors is doing enough to address that fundamental problem, and BMG is no exception. If it concentrates on the short term, BMG seems to think, the long term will somehow work itself out. But doing little is likely the riskiest strategy the company--and the industry--could possibly take.

On the morning after the Grammys, Schmidt-Holtz, 54, is red-eyed and exhausted in his 44th-floor office high above Times Square. He stayed up late schmoozing with stars at BMG's post-Grammy party. Then, perhaps against his better judgment, he let Arista CEO Antonio "L.A." Reid drag him downtown to an "after-after party." Schmidt-Holtz didn't get to bed until 5 A.M.

He seems to shake off his fatigue, however, as he talks about how BMG has changed. Schmidt-Holtz is as surprised as anyone that things have gone as well as they have. "When I first started, it was a terrific recipe for failure," he says. "I was jumping into a business I didn't have a clue about. At the same time BMG was in deep, deep shit. The market was declining. There were times when I wondered, 'What can I do?' "

In January 2001, when Schmidt-Holtz walked in the door, BMG was indeed in sorry shape. Its record labels hadn't turned a profit since 1999. And the company was reeling from the aftereffects of Clive Davis's 2000 ouster, engineered by Schmidt-Holtz's headstrong predecessor, Strauss Zelnick. As part of the deal to get Davis out, Bertelsmann invested $150 million in J Records, an independent label he had started, and allowed Davis to take with him established artists like Luther Vandross and up-and-comers like Alicia Keys. That left virtually nobody in the studio at Arista, BMG's strongest label. The following year sales at BMG fell 30%, to $2.6 billion; earnings before interest and taxes slipped to a negative $353 million.

Bertelsmann's then-CEO, Thomas Middelhoff, vowed to either fix BMG or sell it. First he stripped out the division's music clubs and CD-manufacturing departments so that labels could no longer hide their losses. Then he tapped Rudi Gassner, BMG's former head of international music, to nurse the labels back to health. While jogging in Germany barely a week before he was scheduled to take over the division, Gassner died of a heart attack.

Bertelsmann turned to Schmidt-Holtz. He had never run a music company, and he clearly wasn't the company's first choice for the job. But he had extensive experience in media as editor and publisher of Stern, a leading German newsweekly, and then as CEO of CLT--UFA, the largest free television network in Europe at the time. None of that prepared Schmidt-Holtz for the excesses he discovered at BMG headquarters in New York. He was stunned by how much the money-losing company was spending on flowers for every floor, for example. "It was what my managing director in Malaysia was making!" he says. "I watched my guys take limos because they didn't like to take taxis after 6 P.M. They were renting suites in hotels for their families because they wanted to attend a Grammy party in Los Angeles. I said, 'Wait a minute. Something's completely wrong.' "

In his first two months on the job, it seemed that someone came into Schmidt-Holtz's office with more bad news every day. Whitney Houston was demanding an expensive new contract; BMG agreed to a deal reportedly worth a hefty $100 million. (Amid rumors of drug use, the diva admitted on national television that she "partied"; sales of her subsequent album, Just Whitney, were disappointing.) Around the same time Schmidt-Holtz learned that Clive Calder, then CEO of Zomba, Jive's parent, was exercising an option in his contract requiring Bertelsmann to buy his share of the company for an astonishing $2.7 billion. Meanwhile BMG's primary Internet foray, GetMusic.com, an e-commerce joint venture with Universal Music, was generating hundreds of thousands of page views but hemorrhaging red ink.

In March 2001, Schmidt-Holtz called a meeting of top executives at the Hyatt Regency in Greenwich, Conn. "The first night we went to dinner," says COO Michael Smellie, "Rolf and I sat in a corner and had more than one or two drinks. We discussed how the hell he got himself into this mess and what the hell we were going to do to get ourselves out of it."

Their conclusion: BMG had to slash costs and start churning out more hits fast. So Schmidt-Holtz laid off 1,400 people companywide. He clamped down on the surviving execs' free-spending ways. He pulled out of Greece, India, Turkey, and other markets where BMG acts weren't selling. He focused his dollars where they were most likely to pay off, on recordings from proven stars or especially promising newcomers. And he bailed out of unprofitable Internet distribution businesses like GetMusic.com. The latter move was quite a change. After all, Bertelsmann is the company that once tried to dominate the digital music market by taking a $50 million stake in Napster, the renegade Internet company that later declared bankruptcy.

That's not to say Bertelsmann has completely abandoned the Internet. BMG has licensed its catalog to legitimate downloading sites like Pressplay and Rhapsody. Bertelsmann is a partner with AOL Time Warner (parent of FORTUNE's publisher), EMI, and RealNetworks in MusicNet, a competing service. But Schmidt-Holtz shows little enthusiasm for those ventures. He thinks BMG should be in the business of producing music, not worrying about how it is distributed. "What we need are good songs, good records," he says. "I don't care if they are sold by bicycle, by plane, by CD, online. We'll license them to anybody. But I'm not going to run an Internet platform. I have no clue how to do that."

The cost cuts worked. BMG saved $220 million in 2001, and the company broke even in the second half. L.A. Reid, Davis's replacement at Arista, was getting artists back in the studio. Last year BMG had 24 albums that sold more than a million copies, up from 15 in 2001.

The company is off to a good start this year too. Chocolate Factory, from Jive Records artist R. Kelly, debuted at the top of the Billboard 100 in February--a huge relief for BMG, which feared Kelly's career had been severely damaged by his recent arrest on charges of possessing child pornography. Two of BMG's biggest stars, Arista's Pink and Jive's Britney Spears, are also scheduled to release albums in 2003. "Britney's going to push the envelope without being stupid or contrived. It's going to be really cool," says Jive president Barry Weiss. BMG should be able to increase profits again this year through CD sales alone, COO Smellie insists. "We have a global market share of probably only 12%," he says, "so I think we have a huge amount of room to move."

Soon after BMG began restructuring its businesses, some of its rivals did so too. Warner Music cut its workforce by 12% in the past two years, helping boost the company's cash flow by 15% in 2002. Since mid-2001, EMI has laid off 1,800 people; some executives who stayed took salary cuts of 50%. EMI boasts that its operating profit was up 83% for the six months ended this past September, even though sales dropped by 9%. And there will probably be cuts soon at Sony Music, whose profits Merrill Lynch predicts will fall nearly 75% for the year ending March 2003. "This is about rebuilding the way we do business," says Sir Howard Stringer, chairman of the Sony Corp. of America.

Only Vivendi's Universal Music Group, the world's largest music company, is bucking the cost-cutting trend--even though its revenues declined 1% in 2002 and its operating income fell 23%.

One industry veteran chides the companies for laying off people and calling it a new model for the business. "That's their new model--cost cuts," he scoffs. "Very creative. It's not. They're just thinking about their first year." And the year after that? Well, maybe it won't matter for many of the companies. The industry forecast is so gloomy that many of them are trying to get out of the music business altogether. Vivendi reportedly considered unloading Universal Music last year but decided against it because there was no way to get a decent price. Debt-laden AOL Time Warner is thinking about selling Warner Music. EMI, whose stock price tumbled 61% in 2002, has met with BMG about a possible merger. Analysts say it's increasingly likely that the European Union, which blocked AOL Time Warner and Bertelsmann's attempts to buy EMI in the past few years, would now allow it. Why? Because the music market is simply getting too small to support five big companies.

Like it or not, the way to restore the industry to health is to embrace digital distribution of music via the Internet. Doing so would be difficult but far from impossible. After all, the music business has long survived by introducing new formats: the long-playing record that replaced the 78 single in the 1950s; the cassette in the 1970s; the higher-priced CD, which fueled a huge increase in sales, in the 1980s. Now consumers are clamoring for digital distribution. They want to burn songs they like onto blank CDs or download them onto portable MP3 players for a reasonable price. Seems simple enough, right?

But four years after Napster transformed the music-distribution landscape, the industry still isn't giving consumers what they want. There are currently four digital services that allow consumers to download and burn music legally from the five major record companies: FullAudio's MusicNow, MusicNet on AOL, Pressplay (a joint venture between Universal and Sony), and Rhapsody (in which the five majors own a very small stake). That is a huge step in the right direction for an industry that until fairly recently used piracy as an excuse to do nothing at all on the Internet. But the services are so user-unfriendly that they have together attracted fewer than 400,000 paying customers since they were launched early last year.

Consider the two services that have the industry's strongest backing, MusicNet on AOL and Pressplay. You have to pay $9.95 to $17.95 a month--roughly the same price as a CD--before you can burn anything on either service. Even then, MusicNet on AOL limits you to ten burns a month; Pressplay lets you burn additional cuts for about $1 each. You can't download anything from AOL's MusicNet onto a portable player. Pressplay does let you do that. But you can download only if your device uses Microsoft's Windows Media Player software. Apple's popular iPod isn't compatible.

Schmidt-Holtz says that Pressplay and MusicNet will eventually resolve these problems. "There are at least ten feasible models [for digital platforms], so it doesn't make sense to say this is what it has to be right now," he says. "You can have a subscription model. You can have a track-by-track purchasing model. There are many, many feasible models. I don't care about the models. The platforms have to care."

But BMG needs to care. Those services won't take off until consumers can download and burn everything from the five majors. You can't burn songs by BMG stars Britney Spears and Justin Timberlake, however, because Jive hasn't granted the rights to any of the online services. Nor can you download a single tune by Avril Lavigne, BMG's top-selling artist. Lavigne's manager says that the label has never asked her for the rights. (BMG disputes that.)

This state of affairs doesn't seem to bother BMG executives, none of whom appear to take Internet music distribution very seriously. When FORTUNE asked Arista's Reid about the fact that La-vigne's songs can't be downloaded, he said, "I didn't know. And I don't want to know." He continued, "Honestly, that's just not what I focus on at all. I really feel that my role here and my passion is finding artists and helping them come up with material that we think will work." His attitude is fine with his superiors. Schmidt-Holtz doesn't want Reid to worry about downloading; he wants him to find the next Avril Lavigne.

Despite past foot-dragging, EMI and Universal don't share that indifference. The CEOs of both companies say that digital distribution is a key element of their long-term strategies. Both are speedily licensing downloading and burning rights for songs by their artists--from old-timers like Pink Floyd and the Beach Boys to hot new acts like 50 Cent and Norah Jones. "If we combine digital distribution with physical, we can probably replace the decline in CD sales," says David Munns, CEO of North American recorded music for EMI. Predicts Universal Music CEO Doug Morris: "I believe in two to three years, digital distribution is going to be a substantial part of our business." Shouldn't somebody at BMG be looking that far ahead?

It's the week after his Grammy party, and Clive Davis is still basking in the memory of the evening. Adorning his office are flower arrangements from guests like Aretha Franklin and Carly Simon who wanted to say thanks. "I'm blessed," Davis says. "The party was huge success. It was a magical event. It's becoming an institution. You should read the Liz Smith article where she says that my annual party is like the Vanity Fair Oscar party, but that this is one with heart."

Such accolades mean a lot to Davis, whose ego is legendary even in the music business. (One joke about Clive Davis: He thinks the CD was named after him.) He will be the first to tell you that he could easily be retired by now. He adores Europe in the summer, the Caribbean in the winter. He has four grandchildren. But something keeps drawing him back to music. The thrill he gets from having a hit record, he says, hasn't waned.

Now it is time for Davis to resuscitate RCA, a label better known for its catalog of music by departed stars like Elvis and Glenn Miller than for its current roster. He's spent time with its rock acts like Foo Fighters and the Strokes. He's seen a rough cut of Foo Fighters' new video, and he has high hopes. He looks genuinely surprised when asked if he is thinking about digital sales. "The strategy is one of creativity," Davis says. "Really, the technology I leave to others."

One of his first orders of business is to get a hit out of RCA artist Kelly Clarkson of American Idol fame. Davis has been picking songs for Clarkson's first album and spending time with her in the studio. "She just began," he says. "We feel the songs are great. Want to hear her demo?"

He pops a CD into the stereo system behind his desk. "This girl can sing," he says. "Material is coming from some of the best writers all over the world. So she's hot and heavy into it." He cranks up the volume to an earsplitting level. The music is the sort of formulaic middle-of-the-road fare that Davis used to propel Whitney Houston and Barry Manilow to fame.

It's worked for Davis in the past. But it will take more than a hit or two for BMG to continue to prosper--or, perhaps, to survive.

FEEDBACK dleonard@fortunemail.com