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Why a Plan to Cut CD Prices Went Off Track

By Ethan Smith
Staff Reporter of The Wall Street Journal

A year ago, the world's biggest record company, Universal Music Group, tried a bold gambit to revive the music business: slash the wholesale and suggested retail prices of its CDs. Universal was confident that price cuts of up to 30% would boost business for retailers and please consumers who thought music was too expensive. After all, that's how marketers juice up sales of cars, hamburgers and lots of other merchandise.

Today, the initiative, called JumpStart, is falling apart--for reasons that spotlight the industry's past problems and its still-bleak future.

Cutting prices across the board sounds like a simple proposition, especially for a company that is a leader in its industry. But in the music business, it required upending a convoluted and peculiar system of pricing and incentives. Under this system, retailers pay wholesale prices to buy CDs from distributors, but often get subsidies from the record companies in the form of advertising support and a variety of other side deals, which can dictate where the CDs are placed in stores.

Not a Bargain

With the launch of JumpStart a year ago, Universal tried to do away with the incentives and discounts in favor of a much simpler pricing structure. It lowered the wholesale price of most CDs to $9.09 from $12.12, with the idea that stores would drop their retail price on new releases to a suggested $12.98. Universal Music Chairman Doug Morris said at the time that the new plan would enable most music stores to better compete with the $9.99 retail price that Best Buy and other mass merchants often charge for hot new releases.

Universal figured that the lower prices would drive up sales volume-leading other music companies to follow its example and lower their prices as well.

But with illegal Internet downloading still rampant, consumers didn't view a $12.98 album as much of a bargain. Moreover, many music buyers never even saw the lower prices. A number of music retailers, from Virgin Megastore to FYE, either delayed implementing the price cuts or never adopted them at all. They simply kept charging the old retail prices for CDs they bought at the new, low wholesale prices, and pocketing the difference.

"They were trying to force a new pricing strategy upon us," says Martin Herrmann, a consultant with FTI Consulting, which was working with the ailing Tower Records chain on a bankruptcy filing. Record retailers felt they were the victim of "strong-arm tactics" designed to force them to accept untenably low retail prices, says Don VanCleave, president of the Coalition of Independent Music Stores, which represents 70 retailers in 24 U.S. states.

The various moves "came off as arrogant," concedes Jim Urie, president of Universal Music & Video Distribution. "We didn't mean it that way, but hurt feelings are hurt feelings."

Indeed, Universal misread how music retailers would view the cuts. To the retailers, it seemed that Universal's low-price plan favored their new archrivals, big-box retailers like Wal-Mart Stores and Target. These megastores-which by some estimates now account for as much as 60% of music sales in the U.S.-routinely offer deep discounts on music as a way to lure customers into stores. For them, music is a small piece of the pie. These retailers bet that once music shoppers are in the store, they will decide to buy more expensive items as well-thus making up for the lost revenue on the CDs.

For smaller specialty music retailers, on the other hand, CDs are the primary product, and they need to make a decent profit on them to survive. Music stores can't afford to offer the same discounts because they have few other high-profit-margin product lines to cover the losses.

Consequently, a pricing divide has developed over the past decade. On average, traditional music stores charge at least $1 more for any given CD than the mass merchants do. For new, hot titles, that gap is often bigger. For example, a recent Universal CD by Jay-Z, "The Black Album," sold for $14.98 on average at music stores, compared with $12.76 at mass merchants.

When JumpStart came along, with its emphasis on low, Wal-Mart-type prices, music stores quickly concluded that Universal had sided with the big-box enemy. In fact, Best Buy and Wal-Mart were among the first to adopt the program.

Traditional music retailers also resented that Universal did away with so-called co-op ad payments. In theory, these payments from record labels to retailers pay for local advertising highlighting the labels' current titles. In practice, co-op money often pays for little more than better placement in a store, which costs the retailer nothing. For some retailers, those payments mean the difference between profit and loss-especially when they're competing with deep-discounting big-box stores.

'We Believe in the Program'

Universal has yet to see a significant improvement in its finances since the launch of Jumpstart. For the plan to work, Universal Music needed to see a 21% lift in sales volume to offset the lower wholesale prices. An executive at the company says Universal saw increases of just 8% to 13% most weeks.

Earlier this year, Universal executives partially retreated from many of the price cuts and gave ground in other important areas. The company raised wholesale prices on most titles back to $9.49, but still below their pre-JumpStart levels. Some "superstar" releases now wholesale for $10.35, up from $10.10, and their suggested retail prices have been raised by a dollar, to $13.98. Co-op payments have also been restored to a lesser degree.

At the new prices, Universal executives say the company willow need about a 17% boost in volume to offset the effects of the price cuts." We believe in the program," Mr. Urie says. "Parts have been successful; other parts have been less so."

For the music industry as a whole, the long-term trends are still troubling. World-wide music sales continue to tumble. Internet users download millions of songs illegally every week. Legitimate downloading services like Apple Computer's iTunes are promising, but still in their infancy.

Moreover, traditional music retailers-which the industry relies on to stock older titles that big-box merchants often don't carry-are failing at an alarming rate, thanks to the double whammy of the Internet and discount retailers. Big chains such as Wherehouse Entertainment and Tower Records have recently gone through bankruptcies, while others, such as HMV Group, are planning to close their remaining U.S. stores.