BUSINESSWEEK ONLINE : NOVEMBER 13, 2000 ISSUE
COVER STORY

Bertelsmann: A New Net Powerhouse?
Bertelsmann's deal with Napster could kick-start a bold plan for the media and entertainment giant

Thomas Middelhoff doesn't look up as his Gulfstream jet gains altitude over France's Cote d'Azur. He ignores views of the shimmering Mediterranean and the mist-shrouded Alpes-Maritimes. Instead, the chairman and CEO of Bertelsmann, the world's third-largest media company, is hunched over a pile of newspaper clippings, devouring the day's news from the entertainment and online world. And it has already been a long day. After waking at 5 a.m. in the rural German town of Gutersloh and taking a swim in his indoor pool, Middelhoff has hopped a plane for Cannes to give a pep talk to top executives of BMG Entertainment, Bertelsmann's music division. Then it's back to the airport in a Mercedes whose chauffeur seems to be on loan from Formula One.

Twelve days later, Middelhoff is stepping out of a black stretch limo at New York's Essex House hotel. Waiting outside is the Internet's No. 1 bad boy, 20-year-old Shawn Fanning, the founder of Napster Inc., the 18-month-old Silicon Valley startup that has turned the music industry on its head by creating software that allows people to trade music for free. The lanky German gets out of his limo, walks over to Fanning, rubs his close-cropped head, and hugs him like an old friend. Thirty minutes later, the pair walk into a press conference, where Middelhoff announces a deal that could help transform his once-sleepy publishing house into a powerhouse for the Internet Age. The irrepressible 47-year-old Middelhoff wants to convert Napster from a renegade, cash-starved outfit into the very center of online media distribution and e-commerce.

The deal is as bold, visionary, and complicated as anything to hit the industry in years. Even as he seeks to make Napster a partner, Middelhoff is still suing Fanning's company along with the rest of the industry for facilitating massive copyright infringement. What's more, the industry seems to be winning the suit, and could be closing in for the kill.

But with 38 million users of Napster's service, Middelhoff says it is folly to call them all criminal. For the cyberworld of the future, ''We have to develop business models that are legal, and somebody has to take the lead,'' says Middelhoff. For starters, the audacious German is saying that a profitable business can be built on peer-to-peer file-sharing, the Napster technology that allows people to swap files online ad infinitum.

If Napster complies with this new plan, Middelhoff conceivably will rescue the concept of profitable intellectual property in the Information Age. The dark nightmare of the media industry has been that file-sharing would spread like wildfire in the networked world. First, file-sharers would download music without paying--as they have with Napster. But they wouldn't stop there. Soon any media product that could be digitized--novels, textbooks, magazines, maybe even movies--would lose all copyright protection and be swiped en masse by the denizens of the Net.

Middelhoff's answer: Recruit the thief to protect the jewels. So he is proposing to remake Napster in a fairly basic way. He is lending Napster a modest $50 million to stave off a cash crunch, and may take an equity stake later. Napster will use the money to develop technology and services designed to get users paying for music rather than stealing it. If Napster delivers, Bertelsmann will settle its copyright infringement suit against the upstart company and urge other media companies to do the same. What's more, Bertelsmann wants to cooperate with rivals and turn Napster into a platform for downloading the whole spectrum of media products, including books, films, and magazines from all companies.

Many of the details of this shocker, though, remain unclear. Paramount is the technological challenge: Napster now has to develop a way to track its users and ensure they are paying. Bertelsmann envisions a sort of huge club where members pay a monthly fee of, say, $4.95 for downloads. That could be an enormous marketing opportunity, but only if the technology works smoothly to prevent violations and protect copyright.

What drives him is a near-religious belief in the dominance of the digital world for all media, plus an enormous desire to make his mark as an innovator in this new industry. He wants to make his company No. 1 in the global music business and in media e-commerce, and that means scouring the earth for the deals that will make rivals stand up and take notice. In the Internet world, being first with a new technology is a huge advantage. ''We have to find the second AOL,'' says Middelhoff.

But the Napster deal could just as easily turn out to be a disaster as a triumph, and Middelhoff's brush with greatness could turn into humiliation. To succeed, Middelhoff must get the heads of the four other major record labels--Universal Music, Sony ( SNE), Warner Music, and EMI--and the music-publishing industry to reverse course and play nice with Napster, their No. 1 enemy.

Yet Middelhoff has been laying the groundwork for a truce with Napster at least since early July. That's when he joined the New Economy elite at investment banker Herb Allen's annual schmooze-fest in Sun Valley, Idaho. The idea of linking up with Napster hadn't yet crystallized, but Middelhoff talked to his peers in the media business about how they should respond to the upstart service. In September, Middelhoff began negotiations with Napster, but he kept them a secret until the last minute. He has since been working the phones and has told company insiders that most industry execs are positive.

An inveterate networker, Middelhoff can draw on some long-standing personal connections to further his cause. One of Hollywood's newest music moguls is a close friend of Middelhoff's: Jean-Marie Messier, whose Vivendi ( VVDIY) is about to acquire control of Seagram's ( VO) Universal movie and music groups. Middelhoff sits on Vivendi's board. Middelhoff is also close to AOL ( AOL) CEO Stephen M. Case, who may soon control Warner Music.

TOO CHEAP? Still, Middelhoff concedes it won't be easy to convince the others. ''We have a lot of emotion between Napster and the music industry,'' he says. Off the record, rival executives expressed surprise at Middelhoff's move--and even voiced skepticism that Middelhoff can pull it off. Some music-business executives think the low prices a revamped Napster would charge would infuriate recording artists, who would fear for their royalty checks. Meanwhile, rival systems are developing. Time Warner ( TWX) on Nov. 1 announced its new music-streaming service. And AOL plans to launch an online music subscription service by early next year.

Another stumbling block: It's unclear how far Napster is willing to go to appease the music industry titans. Napster has always said it is reluctant to change its software, which allows users to download music and listen to it whenever they want. But the record companies want to impose encryption software that would limit users' ability to listen. ''This partnership will preserve the integrity of the Napster experience,'' insists Napster CEO Hank Barry.

Finally, even if Napster maintains the software's simplicity, no one knows how many of Napster's 38 million users will pay to download music, or what price they will pay. Surveys show Napster users are willing to pay something--and are not as young as many might think. But no one knows how customers will react to the news of Napster's very corporate deal.

Daunting stuff. If Bertelsmann can't persuade the other music companies to drop the suit, Napster could be shut down by the court and conceivably be held liable for billions in damages for copyright infringement. ''Today's announcement does not bring an end to the court case,'' says Hilary B. Rosen, president and CEO of the Recording Industry Association of America.

The Napster deal is the boldest step yet in Middelhoff's crusade to revamp Bertelsmann. On the face of it, this traditional media company, which started off as a Bible publisher in 1835, is doing just fine without the Net. The company's overall profit rose an enviable 45% this year, to $671 million on sales of $16.5 billion. Strong performances by the recorded music business led by musicians ranging from Whitney Houston to Puff Daddy, and a stable of 100 magazines, including Parents, Family Circle, and McCall's, did the trick. But some of Bertelsmann's historically strongest divisions, such as the book clubs, are losing money. Middelhoff is also convinced that media companies will soon sell most of their wares over the Internet. If Bertelsmann doesn't prepare for that transition, he fears, the venerable company will enter into long-term decline.

What's more, the timing is good for the Germans, who have a war chest to spend. Owned mostly by a German foundation, Bertelsmann has no publicly traded shares, though it would probably fetch a $70 billion market capitalization if it went public. And Middelhoff has plenty of buying power: some $7 billion, largely thanks to an early bet on AOL. He got Bertelsmann to buy a 5% stake in 1994 for $50 million. Middelhoff could use that hoard to scoop up any number of media and Internet companies, whose values have been slashed by the dot-com shakeout.

But can Middelhoff deliver? He idolizes AOL CEO Stephen M. Case as a prophet of the Internet. But when Case was ready to merge with a media company, he chose Time Warner. Bertelsmann's last big acquisition was in 1998, when it bought Random House and became the world's largest publisher of English-language books.

STILL PLUGGING. In the last year, Bertelsmann circled EMI Group, the London-based music and publishing business. But no deal materialized. And as far as the Net is concerned, Hollywood is full of talk about Bertelsmann's stumbles. Back in the spring, Bertelsmann Music Group put out a 10-page press release heralding its entry into the music subscription/download business. In fact, it only started in October, well after Universal Music Group and Sony Corp. both started licensing their music for downloads. BMG says it just took awhile to put up the music group's huge list. And despite denials by both sides, infighting delayed the rollout of getmusic.com, jointly owned by Bertelsmann and Universal music. Middelhoff added to his collection in September, when he bought control of CDNow.com ( CDNW) , a troubled online music retailer.

The Napster deal, by contrast, shows Bertelsmann can move fast. Middelhoff credits his chief of e-commerce, Andreas Schmidt, who worked on virtually nothing else for weeks, for landing the Napster deal. But Middelhoff also took part, phoning counterparts at Napster in the middle of the night when a new idea hit him or spontaneously flying to New York to try to push the deal forward.

Middelhoff's sense of urgency is unmistakable. He isn't seeing much of his five children these days, or his renovated farm and its population of several dozen sheep, goats, and horses. Since taking over as CEO in 1998, he's given seed money to a host of Internet startups, such as Berlin-based Pixelpark, which helps corporations develop a Web presence and now has a stock market value of $1.2 billion. Middelhoff also launched bol.com, an online seller of books and music and holds a stake in barnesandnoble.com.

Middelhoff has ordered that all of Bertelsmann's content be converted to digital form, down to the dust-jacket blurbs on John Grisham legal potboilers. In his vision, customers will download the latest novel from Toni Morrison, a Bertelsmann author, into an electronic book distributed by its partner Gemstar/TV Guide International. BMG will zap Carlos Santana's latest song to fans who pay a subscription fee for the privilege. Europeans will use broadband-Internet connections to follow the real-life soap opera on Big Brother, in which volunteers spend weeks living inside a closed compound, cameras watching their every move. Already, RTL Group--a Bertelsmann joint venture with Pearson PLC ( PSO) and Luxembourg-based Audiofina--operates Europe's most popular television Web site.

To be sure, his properties are dwarfed by an AOL-Time Warner combine. And Bertelsmann's Internet business contributed just 2.5% of sales in the fiscal year ended June 30. But Middelhoff is girding his staff for a Net breakthrough. He has banned paper interoffice memos, accepting only e-mails. He personally answers about 130 a day. He ordered PCs for every employee to use at home. He has forbidden neckties at management board meetings.

Yet Middelhoff's innovations go only so far. Bertelsmann operates according to idiosyncratic management principles established by the company's postwar patriarch, Reinhard Mohn, now 79. The central credo is decentralization. Managers of more than 300 Bertelsmann profit centers get vast management independence as long as they hit profit targets.

Middelhoff is now trying to import some American energy to Gutersloh, where cows graze practically up to the wall of the low-rise Bertelsmann headquarters. Sometimes he wishes he had been born in freewheeling Silicon Valley rather than uptight Dusseldorf. ''Deep in my heart, I'm really American,'' he says. Middelhoff spends close to half his time at Bertelsmann's New York headquarters in the heart of Times Square.

Middelhoff figures he started shedding his German identity on Nov. 2, 1994. That was the day he met Steve Case. Back then, Middelhoff was Bertelsmann's head of corporate development. He arrived for a meeting with Case, thinking he would give the young American a lecture on the media business. He left blown away by Case's vision of an online media empire. Eventually, Bertelsmann's management board agreed to buy 5% of AOL for $50 million. This prescient call boosted Middelhoff's ascension to the CEO slot by demonstrating to patriarch Mohn the power of the new medium. It showed ''he [could] provide the leadership necessary to bring Bertelsmann into the Internet Century,'' recalls Case.

Joining the AOL board, Middelhoff got an apprenticeship in running a company at Net speed. ''In the old days, he was a little bit stiff,'' says Arnold Bahlmann, Bertelsmann's executive vice-president for corporate development. ''The AOL thing changed him a lot.'' One example came in 1998, when underling Schmidt assumed management of AOL Europe. During a meeting about AOL Europe that included Middelhoff, Case, and AOL President Robert W. Pittman, the brash Schmidt sprung a plan to spend an eye-popping $2 billion on expansion over 2 1/2 years. Schmidt didn't bother to clue in Middelhoff beforehand. Many CEOs would have been enraged. Middelhoff, Schmidt says, just laughed and went on to back much of the plan.

NEW STRATEGY. Analysts interpreted the AOL-Time Warner merger as a serious setback for Bertelsmann, but Middelhoff refuses to see it that way. He's certain that ''preferred provider'' agreements will protect Bertelsmann's access to the world's largest online service, even though the company is now unwinding its AOL stake.

But the breakup with AOL was a blow. He decided Bertelsmann would focus on media, not the business of providing Internet access. That puts Bertelsmann in marked opposition to the rest of the media industry, which figures it needs ''pipe''--via cable, wireless, or broadcast--to guarantee premium placement of a company's content, online and off.

In any event, Middelhoff faces plenty of challenges in the online ventures he already has, as well as more traditional areas. His bol.com is gaining on Amazon.com Inc. ( AMZN) in countries where they compete, but still trails. Barnesandnoble.com ( BNBN), a joint venture with Barnes & Noble Inc. ( BKS) in the U.S., is struggling.

As Middelhoff charges forward, there's one thing he won't have to worry about. Stockholders. A few months ago, people thought that was a handicap. Now, Wall Street analysts are changing their tune. ''If he can take care of his employees, do his business, and raise cash from his bankers, why go through the grief?'' says Tom Wolzien, media analyst at Sanford C. Bernstein & Co. in New York.

To be exact, there is one shareholder Middelhoff still needs to worry about. But patriarch Mohn, who with other members of his family, still owns a 21.4% stake, has urged Middelhoff to push forward a transformation every bit as dramatic as the one Mohn led after World War II. The Napster ploy shows that Middelhoff has gotten the message.

By JACK EWING
With Spencer Ante and Tom Lowry in New York, Ronald Grover in Los Angeles, Catherine Yang in Washington, and bureau reports

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