From Sour Notes to Right Keys

The champagne flowed freely at the posh Argyle Hotel on Grammy night as Bertelsmann Music Group Chairman Rolf Schmidt-Holtz toasted the victory of his latest star, Alicia Keys, who took home five awards, tying a record for the most by a female artist on a single Grammy telecast.

The soul singer’s success and her critically lauded debut album, “Songs in A Minor,” have put the German music giant back on the map. Keys’ album has sold 8 million copies worldwide and generated $10million in profit for BMG’s new J Records, a joint venture with legendary music executive Clive Davis. Keys’ breakthrough was a sweet surprise for BMG, which has weathered years of bad press, threats by artists to leave the company, management turmoil and financial setbacks.

These days, BMG appears to be making progress in repairing its struggling Arista and RCA labels, which have delivered hits by Outkast, Pink, Usher and Alan Jackson. So far this year, BMG has four of the top 10 best-selling records and ranks second in U.S. market share among the five major music corporations.

Not bad for a music company that was in such dire shape last year that its German parent, Bertelsmann, the world’s fourth-largest media conglomerate, considered getting out of music altogether.

Bertelsmann’s $17 billion in sales last year came from many sources, including music, book publishers Random House and Gruner & Jahr and Europe’s TV behemoth RTL Group. And Bertelsmann Chief Executive Thomas Middelhoff is preparing the company, founded in 1835, to go public.

Fixing Bertelsmann’s music business, though, has taken a lot of effort. For the fiscal year ended in June, BMG’s $3.2 billion in sales marked a 12% drop from two years earlier. Schmidt-Holtz refused to discuss the financial details of BMG’s downfall--as did BMG’s Chief Operating Officer Michael Smellie. Company sources, however, said political infighting and other mistakes made under the previous management cost BMG about $400 million in operating losses in fiscal 2001.

As part of a management shakeup, Middelhoff forced out BMG’s top two executives, Michael Dornemann and Strauss Zelnick, whom the corporation now blames for most of the music unit’s financial and morale problems. Fifteen months ago, Middelhoff installed Schmidt-Holtz, 53, a former TV executive, as BMG’s music chief. Since then Schmidt-Holtz has announced 1,500 layoffs worldwide after discovering, among other things, that BMG’s North American music division had not posted a profit since it was launched in 1997.

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‘Starting to See Signs of Life’

With the help of some hit records and cost cutting, BMG says it broke even in the last six months of 2001 and expects to turn a $100-million-plus operating profit for 2002.

“We’re finally starting to see signs of life after a long, disastrous turn of events,” Schmidt-Holtz said in his first extensive interview since taking over the music company.

“When I arrived, what I found was a company in shambles. A financial mess. A political nightmare. We had lost all credibility with our artists and our labels. We had lost the backing of our own shareholders. Nobody believed in BMG. And why? All because of ego and arrogance on the part of BMG managers. Corporate arrogance nearly killed this company.”

BMG blames Dornemann and Zelnick for infuriating the artistic community after driving Davis from power at Arista, the label he founded 25 years ago and now is home to Santana and Whitney Houston. Dornemann and Zelnick also locked horns with Zomba Group record chief Clive Calder, head of BMG’s other top creative engine, which releases music by Britney Spears, the Backstreet Boys and ‘N Sync.

Dornemann would not comment about BMG. Zelnick issued a statement that said, “I spent six enjoyable years at BMG. I am proud of the work I did and of my team’s performance.”

Bertelsmann fired its controversial management team, but was forced to enter an expensive, face-saving joint venture to keep Davis that cost BMG more than $100million in start-up costs for the J label and permitted him to raid Arista of dozens of top executives and artists, including Keys. It also means Bertelsmann reaps only 50% of the profit from J, including Keys’ hit album.

Dornemann and Zelnick squandered hundreds of millions of dollars, sources say, on a variety of misguided ventures, according to an internal company audit of BMG commissioned by Bertelsmann.

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Corporate Infighting Damaged Credibility

The corporate drama that decimated BMG has drawn comparisons to similar upheavals that ravaged music divisions at AOL Time Warner Inc. and EMI Group, which led to an exodus of top executives and artists as well as a massive erosion in profit and market share.

“Quite simply, all of this political infighting robbed [BMG] of its credibility,” COO Smellie said. “It hurt us. There’s no point in pretending it didn’t. The creative values of the company were severely eroded. It’s a hard thing to turn a company around after devastation like this.”

A big chunk of BMG’s losses stems from an estimated $60 million in severance packages for Dornemann, Zelnick and other former executives, including former BMG tech guru Kevin Conroy, according to company sources. That’s more than half of the additional $100million paid in exit packages for the 1,500 employees who are losing their jobs during the restructuring of BMG’s corporate operation.

The company also was forced to write off more than $40 million in Internet investments, direct-marketing schemes and other botched ventures launched by Zelnick and Conroy with Dornemann’s approval. BMG racked up an additional $40 million in losses for its German division after management problems there and a significant downturn in the music market.

But BMG’s biggest financial hit stemmed from the Arista fiasco, in which the company ate nearly $100million in write-offs and lost revenue last year. By the time Davis left the label, the clever entrepreneur had emptied the talent pipeline at Arista.

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Millions Spent to Pacify Top Artists

When new Arista President Antonio Reid arrived, there was little product to release, no artists in the studio and few executives left to run the label. The result: BMG’s hottest creative engine released only a few records during the first six months of 2001, which cost the company an estimated $50 million in sales. In addition, sources say Reid spent about $25 million hiring a staff, signing acts and renegotiating several key deals to pacify top artists, including Whitney Houston, who were upset about Davis’ departure. Reid also racked up about $25 million in write-offs as he cleaned house at Arista, cutting ties with a variety of acts and executives before starting over.

This does not account for the $100 million BMG previously paid to Reid and his partner to buy the second half of their Atlanta-based LaFace label--a move by Zelnick to lure him to New York to replace Davis at Arista.

“You know people talk about temperamental artists, but these are gifted individuals who create music,” Schmidt-Holtz said. “What do arrogant executives bring to the table? Nothing at all. In fact, they destroy value. They open a company up to risk. And in the end, their bungling causes thousands of people to lose their jobs.”

Schmidt-Holtz said he had no idea that BMG was in such bad shape when he agreed to take over. Neither did the company’s executive committee until last March, when he shared the results of an internal audit that detailed BMG’s financial state.

“The committee’s first reaction was, ‘It can’t be true,’” he said. “They thought I was kidding.... The truth was a real shock for them. I said, ‘Listen, either we drastically change the way we do business or we die.’”

Schmidt-Holtz and Smellie implemented a massive overhaul designed to save Bertelsmann nearly $200 million by the end of 2001.

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Plan to Capitalize on Elvis Presley Treasures

The pair significantly slashed BMG’s artist roster and orchestrated its exit from music deals in small markets such as Turkey and the Scandinavian nations.

They also cut acts in the U.S., shut down RCA’s urban division and dumped several money-losing joint-venture labels.

BMG is negotiating an end to its joint venture with Bad Boy founder Sean “P. Diddy” Combs, who it will pay more than $30 million to leave. The Bad Boy label reportedly is losing $25 million a year.

Schmidt-Holtz also has decided to unleash an international Elvis Presley campaign, hoping to capitalize on RCA’s vault of Presley treasures.

A package of Presley hit singles is scheduled for release in some markets before year’s end.

“We feel quite good about how J and Arista and RCA are progressing,” Smellie said. “But of course, when you dig around and discover how much money it cost to get where we are, and how wacky the decision-making process was, you almost have to scratch your head and say, ‘It’s a little like Alice in Wonderland, isn’t it?’”