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We're going to reinvigorate the record business in North America.

Our new pricing policy will allow us to take the initiative in making music the best entertainment value and most compelling option for consumers. UMG is responsible for almost 30 percent of album sales in the U.S. so we are uniquely positioned to try this new strategy .... We strongly believe that when prices are dramatically reduced on so many titles, we will drive consumers back to stores and Significantly bolster music sales. I

CASE

EMI Group, PLC

CD Pricing in the Recorded Music Industry

On September 3, 2003, Doug Morris, chairman and CEO of Universal Music Group (UMG), stunned the music industry with a surprising announcement. As the worldwide sales leader in the recorded music industry, UMG announced its intention to reduce the suggested retail prices in North America on nearly all its CDs to $12.98 beginning in early October. According to Mr. Morris:

On September 4, 2003, senior executives at EMl Group, PLC, the world's third largest music company, witnessed a 10 percent drop in the company's stock price. Industry analysts speculated that EMI and other music companies would be forced into a potentially damaging price war in the United States. According to one industry analyst, "Universal already has so much market share in the U.S., and the price cuts mean that they will probably take even more retail shelf space,"?

Alain Levy, chairman and CEO- EMI Recorded Music, declined to say what action, if any, EMI would pursue in response to UMG's announced price cut in North America, and particularly the United States. He and other EMI senior executives thought that UMG's pricing action would have to be examined carefully given the size of the North American recorded music market and EMl's competitive position in the United States. North America is the world's largest market for recorded music and the source for almost one-third of EMI's total revenue and about 27 percent of the company's operating profit in fiscal 2003 (year-end March 31, 2003).3

I Ethan Smith, "Universal Slashes CD Prices in Bid to Revive Music Industry," Wall Street fournal (September 4, 2003), pp. B 1, B8;"Universal Music Group Dramatically Reduces CD Prices," TheWebNewsroom@azreporter, September 3, 2003.

2 Annie Lawson, "EMI Feels the Squeeze Over CD Price Cuts," media.guardian.co.uk (September 5, 2003); "EMI Group PLC:Universal Music's Price Cuts, Merger Talks Hit Share Price," Wall Street fournal (September 5, 2003), p. B4.

3 EMI Group, PLC, 2003 Annual Report, p. 66.

This case was prepared by Professor Roger A. Kerin of the Edwin 1. Cox School of Business, Southern Methodist University, as a basis for class discussion and is not designed to illustrate effective or ineffective handling of an administrative situation. This case is based on published sources including company annual reports, SEC filings, company and industry news releases, published articles, and information provided by individuals knowledgeable about the industry. Consequently, the interpretation and perspectives presented in the case are not necessarily those of Universal Music Group or EMI Group, PLC or any of their employees. Where appropriate, quotes, statistics, and published information are footnoted for reference purposes. Copyright © 2004 Roger A. Kerin. No part of this case may be reproduced without the written permission of the copyright holder.

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450

CHAPTER 8 PRICING STRATEGY AND MANAGEMENT

• THE RECORDED MUSIC !NDUSTRY

The recorded music industry consists of companies engaged in releasing, promoting, and distributing musical recordings. These companies manufacture or arrange for the manufacture of CDs, audio cassettes, vinyl records, music videos, and audio and video DVDs and promote and distribute these products to retailers or directly to the public. Companies in this industry produce master recordings themselves, or obtain reproduction and distribution rights to master recordings produced by other record companies. The industry employs singers, musicians, sound engineers, music promoters, CD manufacturing and warehouse workers, record store management and clerks, and music company administrative staff, including marketing, public relations, and sales personnel.

Industry Size and Developments

Thfl GROup, PLC

EXHIBIT 1

451

Unit Sales Trend for CD Albums in the United States: 1993-2003 est.

Units sold
(in millions) t
1,000
900
800
700
600 DO
500
400 1998 Year

2003 est

1993 1994

1995 1996

1997

1999

2000 2001

2002

Source: 1993-2002 data are provided by The Recording Industry Association of America's 2002 Yearend Statistics. Used with permission. The 2003 estimate is based on "RlAA Releases 2003 Mid-Year Shipments," RlAA Press Release, August 29, 2003.

Music industry executives acknowledge that CD downloading and burning represents a popular trend that will grow with the use of broadband Internet connections. Music companies now authorize online stores to sell digital songs. These authorized stores include i'Iunes Music Store owned by Apple Computer, Rhapsody, MP3.com, Buymusic.com, and Musicnet.com. The cost per individual song ranges from $.79 to $.99. However, file sharing Web sites such as KaZaA, Grokster, and Morpheus are not authorized by music companies to download songs.

The Recording Industry Association of America (RlAA), which represents music companies, has initiated numerous programs designed to educate consumers and government officials in the United States and European Union on the legal and economic implications f unauthorized CD downloading and CD burning. In early September 2003, RlAA filed 261 separate lawsuits in the United tates against individuals .ngaged in unauthorized file haring. Industry analysts expected that litigation would have a 'l'l rt-run clamJ nin f£ -t on unauth nz d w 11 aging and burnlng. However,

litigation i wd as havlng a minim:tl1t::mS;nJn 'ffL't em thl s.

Comptltlon in the Recorded Mu Ie Indutry

Th - recorded music indu try is ry ornp uti -. A rnusi company's mp tithe p ition depend on its ability to attract, develop, and promote recording artists, the public acceptance of those artists, and the number and popularity of a company's recording released in a particular period. A company's revenues and profits are driven by hit recordings, with a relatively small proportion of new releases in a given year commanding the majority of sales. Industry sources estimate that superstar artist recordings account for 50 percent of a major music company's unit sales in a typical year.

unit of Vivendi

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CHAPTER 8 PRICING STRATEGY AND MANAGEMENT

EXHIBIT 2

Worldwide Market Shares of the Top Five Music Companies: 1999-2002

• Year
Company 1999 2000 2001 2002
Universal Music Group 21.7% 22.9% 23.5% 25.9%
Sony Music Entertainment 17.0 14.4 14.7 14.1
EM! Group, PLC 1l.8 13.5 13.4 12.6
Warner Music Group 1l.4 12.0 11.9 11.9
BMG Entertainment 10.1 8.4 8.2 11.1
Total 72.0% 71.2% 71.7% 75.6%
Source: Company annual reports. Advertising, promotion, and publicity for artists and recordings are central elements in a music company's marketing program. Marketing and promotion expenses (including media advertising) represent a sizeable percentage of a music company's costs. Public appearances and performances are also important in the marketing of artists and recordings. Music companies arrange for television and radio appearances and provide financing for concert tours.

Five music companies dominate the global recorded music industry and the recorded music market in the United States. They are Universal Music Group, Sony Music Entertainment, EM! Group, Warner Music Group, and BMG Entertainment. These five companies commanded 75.6 percent of the global recorded music market for Ds and audio DVDs in 2002. Exhibit 2 shows the worldwide market share of the five major music companies for the period 1999 through 2002.

453

Motown catalog, which includes The Four Tops, Marvin Gaye, The Supremes, and The Jackson Five. Through Universal Music Publishing Group, UMG is one of the leading ~obal music publishing companies with over one million owned or administered titles including some of the world's greatest songs, such as Strangers in the Night; Respect; I Want to Hold Your Hand; Candle in the Wind; and I Will Survive. Among the significant artists and songwriters represented are U2, Prince, Chuck Berry, The Beach Boys, Leonard Bernstein, Anastacia, Bjork, and Emilio and Gloria Estefan,

UMG markets its recorded music in 71 countries. The company derives 44.2 percent of its revenue from North America and 41.2 percent from Europe. According to the 2002 Vivendi Universal Annual Report (year-end December 31, 2002), UMG revenues decreased by 4 percent in 2002 and operating income was 556 million euros, down 22.7 percent from 2001. UMG recorded a loss of 42 million euros in the first six months of 2003 (1 euro = US $1.15).

Sony Music Entertainment Sony Music Entertainment is a unit of Sony Corporation, the world's leading consumer electronics company. Sony Music Entertainment itself has three divisions: Sony Music (U.S. music operations), Sony Music International (music operations outside the United States and Japan), and Sony ClassicaL The company markets its recorded music in 60 countries.

Sony Music Entertainment is the world's second largest music company. Its major recording labels include Columbia, Epic, Sony Classical, Legacy Records, Sony Nashville, and Sony Music Soundtrax. Artists who record for Sony Music Entertainment include AC/DC, Aerosmith, Marc Anthony, Tony Bennet, Black Sabbath, Miles Davis, Destiny's Child, Dixie Chicks, Celine Dion, Bob Dylan, Beyonce Knowles, Jennifer Lopez, Wynton Marsalis, Ricky Martin, John Mayer, Pearl Jam, Shakira, Will Smith, Bruce Springsteen, and Barbra Streisand.

A joint venture operated by Sony Music Entertainment, Sony Music Entertainment Japan, and Michael Jackson, called Sony/ATV Music Publishing, owns or administers copyrights for music artists, including Hank Willianls, Roy Orbison, and The Everly Brothers. In addition, the company has a large catalog of recordings it markets, licenses, and sells. Industry analysts estimate that about one-third of Sony Music Entertainment's sales are derived from North America. According to the 2003 Sony Corporation Annual Report (year-end March 31, 2003), the company registered a 5 percent decline in fiscal 2003 music sales with an operating loss of $72 million.

Warner Music Group Warner Music Group is a unit of AOL Time Warner. AOL Time Warner is the world's leading media and entertainment company whose businesses include interactive services, cable TV systems, filmed entertainment, television networks, music, and publishing.

Warner Music Group is the world's fourth largest music company. Its major recording labels include Warner Brothers, Atlantic, Elektra, and Word. Its artist roster includes Josh Groban, Enya, Kid Rock, Faith Hill, Red Hot Chili Peppers, Linkin Park, Missy Elliott, P.O.D., Michelle Branch, and Nappy Roots. The Warner Music International division of the Warner Music Group operates through various subsidiaries and affiliates and their nonaffiliated licensees in over 70 countries around the world. Warner/Chappell, the music publishing division of the Warner Music Group, owns or controls the rights to more than one million musical compositions. Its catalog includes works from Madonna, Staind, Barry Gibb, George and Ira Gershwin, and Cole Porter. Warner/Chappell also administers the music 0 several television and motion picture companies, including Lucasfilm, Ltd. and Hallmark Entertainment. Industry analysts estimate that over half of Warner Music Group's sales are derived from North America.

According to the 2002 AOL Time Warner Annual Report (year-end December 31, 2002), Warner Music Group recorded a 4 percent increase in sales in 2002 and posted

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CHAPTER 8 PRICING STRATEGY AND MANAGEMENT

an operating loss of $l.3 billion." Warner Music Group reported an $8 million loss in the first half of 2003.

BMG Entertainment BMG Entertainment is a unit of Bertelsmann AG, a German corporation. Bertelsmann is one of the world's largest media firms with interests in book and magazine publishing, recorded music, and broadcasting.

BMG Entertainment is the world's fifth largest music company with operations in 41 countries. Its major recording labels include Ariola, Arista Records, Jive Records, RCA, and Zomba Records. Artists who record for BMG Entertainment include Backstreet Boys, Christina Aguilera, Clint Black, Dave Mathews Band, Foo Fighters, Kenny G, Whitney Houston, Alicia Keys, Sarah McLachlan, Britney Spears, Santana, TLC, and George Winston. In addition, BMG Music Publishing owns the rights to more than 700,000 popular and classical titles by artists such as Elvis Costello, Eurythmics, Aretha Franklin, Puccini, and Verdi.

BMG Entertainment derives 44.1 percent of its revenue from the United States and 37 percent from Europe. According to the 2002 Bertelsmann AG Annual Report (year-end December 31,2002), the company reported a 9 percent drop in recorded music revenue and an operating income of 226 million euros. However, BMG Entertainment posted a loss of 117 million euros in the first half of 2003. In early September 2003, the parent companies of BMG Entertainment and the Warner Music Group engaged in discussions to merge their respective music companies. The. discussions ended without an agreement in mid-September 2003.

Economics of Recorded Music: CD Prices and Costs

Profitability in the recorded music industry is determined, in large measure, by the costs of CD manufacturing, distribution and marketing, consumer demand for CDs, competition among music companies, and the prices for alternative forms of recorded music and entertainment. The importance of CDs to the recorded music industry lies in the fact that over 90 percent of industry sales revenue is generated by CD sales.

CD Prices

61'11 > p rating loss was du primaril' t ,I $1.. 99 Billiot good UI an I thet I ntatlj;\1 hi , Iu.~'et Impllirm fit charge in 200_. Without this harge.warner Musi . Group would hay' rc ord d a $ .R2 milljo!'l pruth <I." measured by EBlTDA earnings before interest, taxes, depreciation, an I amortization).

7 Jennifer Odronez, "CDs on the Discount Rack," wsjclassroomeditlon.com, September 2, 2003.

EM! GROup, PLC

455

The remaining 50 percent of industry unit sales are split between these latter two price points in a typical year (35 percent of unit sales are at $17.98; 15 percent of unit sales are at $16.98). A short-term promotional "developing artist" list price of $12.98 is sometimes used. In addition, music companies provide discounts off the MSRP to retailers that are occasionally passed on to recorded music buyers in the form of lower prices. The typical retailer gross profit margin is 36.7 percent on the MSRP for a CD album. However, mass merchandise stores often sell CD albums below the MSRP and thus at a lower retailer margin.

CD Costs The unit cost of CD manufacturing, distribution, shipping, artist and songwriter royalties, and retailer incentives is reflected in CD album prices. A music company's unit variable cost for CD manufacturing, distribution, and shipping is $1.92. Cooperative advertising allowances and discounts given to retailers, both variable costs, total $.85 per unit. These variable cost categories and dollar amounts are the same across music companies and the three CD album price points in the industry. Artist and songwriter dollar royalty amounts will vary according to the price at which music companies sell their CD albums to retailers. These royalties are a fixed percentage of the price at which music companies sell CD albums to retailers. This figure averages 18.5 percent. For example, a CD album with a $16.98 MSRP would be sold to a retailer for $10.75 (a 36.7 percent retail gross profit margin); the artist and songwriter royalty per unit would be $l.99 (18.5 percent of $10.75). Sales and marketing expense and music production are typically fixed overhead expenditures and considered part of a music

company's selling, general, and administrative cost. -

The U.S. Recorded Music Market

The United States is the largest single country market for recorded music. Therefore, music companies pay particular attention to consumer buying trends and their respective competitive positions in the United States.

Profile of Recorded Music Buyers Research conducted on behalf of The Recording Industry Association of America details the profile of recorded music buyers in the United States. Results from this research are shown in Exhibit 3 on page 456.

Rock is, and has been for the past decade, the single most popular musical genre when buyers are asked to classify their music preference. Rap and hip-hop replaced country music as the second most popular musical genre in 2000. Full-length CDs (albums) represent 90.5 percent of all recorded music purchases.

There is no material difference between men and women in the incidence of purchasing recorded music. Slightly over 25 percent of recorded music buyers are 45 years old or older. Another 25 percent are between the ages of 15 and 24. The 15-24 age group represented about 32 percent of recorded music buyers from 1993 to 1996. However, this age group has been identified as the most activ downJoaders and CD burners in the United States today. According to Edison Media Research, 56 percent of 12- to 17-year-olds and 44 percent of 18- to 24-year-olds are downloading music files off the Internet. Half of all Americans between the ages of 12 and 24 are burning their own music CDs. Nearly three out of four teens and 60 percent of 18- to 24-year-olds do not believe there is anything morally wrong about downloading music without paying for it even though this practice is illegal. Four in ten teens and one-fourth of 18- to 24-year-olds believe paying for music is a "thing of the past."

8 "Study Links Burning and Downloading to Falling Music Sales," writenews.com,]une 20, 2003.

456 CHAPTER 8 PRICING STRATEGY AND MANAGEMENT
EXHIBIT 3
Profile of Recorded Music Buyers in the United States: 1993-2002
Year
Music Genre 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Rock 30.2% 35.1% 33.5% 32.6% 32.5% 25.7% 25.2% 24.8% 24.4% 24.7%
Rap/Hip-Hopl 9.2 7.9 6.7 8.9 10.1 9.7 10.8 12.9 11.4 13.8
R&B/Urban2 10.6 9.6 11.3 12.1 11.2 12.8 10.5 9.7 10.6 11.2
Country 18.7 16.3 16.7 14.7 14.4 14.1 10.8 10.7 10.5 107
Pop 11.9 10.3 10.1 9.3 9.4 10.0 10.3 11.0 12.1 90
Religious> 3.2 3.3 3.1 4.3 4.5 6.3 5.1 4.8 6.7 6.7
Jazz 3.1 3.0 3.0 3.3 2.8 1.9 3.0 2.9 3.4 3.2
Classical 3.3 3.7 2.9 3.4 2.8 3.3 3.5 2.7 3.2 31
Soundtracks 0.7 1.0 0.9 0.8 1.2 1.7 0.8 0.7 1.4 11
Oldies l.0 0.8 1.0 0.8 0.8 0.7 0.7 0.9 0.8 0.9
New Age 1.0 1.0 0.7 0.7 0.8 0.6 0.5 0.5 1.0 0.5
Children's 0.4 0.4 0.5 0.7 0.9 0.4 0.4 0.6 0.5 0.4
Other? 4.6 5.3 7.0 5.2 5.7 7.9 9.1 8.3 7.9 8.1
Product Form
Full-Length CDs 51.l 58.4 65.0 68.4 70.2 74.8 83.2 89.3 89.2 90.5
Full-Length Cassettes 38.0 32.1 25.1 19.3 18.2 14.8 8.0 4.9 3.4 2.4
Singles (All Types) 9.2 7.4 7.5 9.3 9.3 6.8 5.4 2.5 2.4 1.9
Music Videos/Video
DVDs5 1.3 0.8 0.9 1.0 0.6 1.0 0.9 0.8 1.1 0.7
DVD Audio" NA NA NA NA NA NA NA NA 1.1 1.3
Digital Download? NA NA NA NA NA NA NA NA 0.2 0.5
Vinyl LPs 0.3 0.8 0.5 0.6 0.7 0.7 0.5 0.5 0.6 0.7
Age
10-14Years 8.6 7.9 8.0 7.9 8.9 9.1 8.5 8.9 8.5 8.9
15-19Year 16.7 16.8 17.1 17.2 16.8 1- .8 12.6 12.9 13.0 13.3
20-24 Years 15.1 15.4 15.3 15.0 13.8 12.2 12.6 12.5 12.2 11.5
25-29Year 13.2 12.6 12.3 12.5 11.7 11.4 10.5 10.6 10.9 9.4
30-34 Years 11.9 11.8 12.1 11.4 1l.0 1l.4 10.1 9.8 10.3 10.8
35-39Year 1l.1 11.5 10.8 11.1 11.6 12.6 10.4 10.6 10.2 9.8
40-44 Years 8.5 7.9 7.5 9.1 8.8 8.3 9.3 9.6 10.3 9.9
45+ Years 1 • .1 15.4 16.1 15.1 16.5 18.1 24.7 -3.8 2 .7 25.5
~~.; . .2.11 41).9 l.R .0.8 _,'1 ~(\.8
1]. .1 :m.J &1. ~ • ! ~, . ~O.·
12.9 L.. 1 .~ 11. .0 6,1 -1,9
3. . 0 Z. '1..7 2. 2.5 2 . 3.0 2.;
NA NA NA NA !!.& 1.1 J. .. ; .. . .11 ~...I
G(mder
r mal 1.. .7 1.' ~O.6
Mal • S.7 ~O.~ I'lJI ·j9.1
I "Rap": Includes rap (10. % and hlp-hop (3.3% .
2 "R&B": Includes R&B, blues, dance, disco, funk, fusion, Motown, reggae, soul.
~ "Rebgious": Includes Christian, gospel, inspirational, religious, and spiritual.
·j"Other": Includes ethnic, standards, big band, swing, Latin. electronic, instrumental, comedy, humor, spoken word, exercise, language,
folk, and holiday music.
s 2001 is the first year that music video DVD was recorded separately.
62001 is the first year that data was collected on DVD audio and digital download purchases.
7"Internet": Does not include record club purchases made over the Internet.
Source: Recording Industry Association of America. Used with permission. Columns may not total 100%. 457

More than 87 percent of recorded music buyers purchase their music at retail stores. Major chain record stores (e.g., Tower Records, Wherehouse Entertainment) have lost their status as the primary buyer source for recorded music. In 2002, "other" stores (notably mass merchants; e.g., Best Buy, Kmart, Target, and Wal-Mart) accounted for 50.7 percent of recorded music purchases. These stores often treat recorded music as a "loss leader" featuring lower than manufacturers' suggested retail list prices to increase store traffic. For example, retail analysts estimate that CDs account for between 5 percent and 20 percent of Best Buy's sales. However, CDs draw as many as 50 percent of the store's customers." Related research indicates that recorded music buyers perceive greater value for the money spent at mass merchandise stores than chain record stores and are attuned to price differentials across retailers.'?

Competitors The same five music companies that dominate the global recorded music industry also command a dominant share of recorded music sales in the United States. These five companies account for slightly more than 85 percent of U.S. recorded music sales. Music company market shares in the United States as of August 2003, are shown below:"

Music Company Universal Music Group Warner Music Group BMG Entertairunent

Sony Music Entertairunent EMI Group, PLC

Others

u.s. Market Share 29.4% 16.6

16.3

13.0

9.8 14.9 100.0%

• EMI GROUP, PLC

EM! Group, PLC is the world's third largest music company. It is the world's largest independent music company, not being a unit, subsidiary, or division of a larger corporation. EMI's headquarters are located in London, England.

Company Background

Electric & Musical Industries (EM!) was established in 1931. In 1955, the company bought Los Angeles-based Capitol Records, which featured artists such as Frank Sinatra and Nat "King" Cole. In 1962, The Beatles signed their first contract with Parlaphone, an EMl record label, and their hit single, "Love Me Do," was released. In 1979, EMl merged with Thorn Electrical Industries, a large British appliance and electronics company. The

cmpan was renamed Thorn EMl. rom EM! a qulr -d a 0 percent int r in Chrysalis Records in 1989. Th following y as th ornpany purchased Filmtrax 111.1 Ic publishing. In 1992, the company bought the Virgin Mu ic Group from Richard Branson. This purchase boosted the company's share of the U.S. recorded music market and made it one of the world's major music companies.

9 Ethan Smith, "Universal's CD Price CutsWill Squeeze Music Retailers," Wall Street journal (September 18, 2003), pp. Bl, B4.

10 "Cracking the Value Code: An Early View," NARM Research Briefs, National Association of Recording Merchandisers,June 2002.

II Market share data are reported in Ethan Smith, "Universal Slashes CD Prices in Bid to Revive Music Industry," Wall Street Journal (September 4, 2003), pp. B 1, B8.

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CHAPTER 8 PRICING STRATEGY Ai'lD MANAGEMENT

In 1996, Thorn EMI split into separate companies and EM! Group, PLC was formed. The purchase of half interest in Berry Gordy's jobete companies (subsequently increased to 80 percent) and its 15,000-song Motown catalog soon followed. In the late 1990's, EM! continued to purchase additional record labels. In 2000, merger talks with Time Warner's Warner Music Group were conducted, but stopped with the merger of AOL and Time Warner. EM! subsequently engaged in merger talks with Bertelsmann AG and BMG Entertainment in 2001. However, negotiations ended due to pressure from European Union regulators.

On September 22, 2003, EM! reported that it began nonexclusive discussions with AOL Time Warner with regard to a possible transaction involving the recorded music division of the Warner Music Group. EM!'s press release indicated the discussions were preliminary. Any potential transaction would be subject to shareholder and regulatory approval. 12

EMI's Music Business

EMI's music business is comprised of two main groups: (1) EMI Recorded Music and (2) EM! Music Publishing. EMI Recorded Music accounted for 81.6 percent of EM! Group PLC's sales and 59.3 percent of the company's operating profit in fiscal 2003 (year-end March 31, 2003).

EMI Recorded Music EM! has over 100 recording labels featuring some of the greatest rock and pop artists in recorded music history. Its major recording labels include Capitol Records and Capitol Records Nashville, Chrysalis, EM! Classics, Java Records, Mosaic Records, Mute, Pariaphone, and Virgin Records America, Nashville, and UK. Its artists, with major albums in 2002 and 2003, include David Bowie, The Beatles, Blue, Coldplay, Utada Hikaru, N0ra11 Jones, Atomic Kitten, Paul McCartney, Kylie Minogue, Massive Attack, Queen, Rolling Stones, Snoop Dogg, and Robbie Williams. Other artists on its roster include Garth Brooks, Ice Cube, Janet Jackson, Pink Floyd, Radiohead, and Smashing Pumpkins. Norah Jones, and her debut album Come Away unth Me, was the recipient of eight Grammy Awards in February 2003. Over 13 million copies of this album have been sold worldwide.

Looking forward toward the 2004 fiscal year (beginning April 1, 2003), Alain Levy, chairman and CEO-EM! Recorded Mu ic, aid:

Looking ahead to the current financial year, the markets are likely to remain challenging. However, we ar . confident of being able to fa the j LIes, both in t rrus of supplying high-quality music, for which there is growing demand, and in maximizing the re enue EMl Recorded Mu ie generates from this music. On this basis, we expect to improve marker ·hay,.11

12 "EMI Group PLC Entering into Non-exclusive Discussions with AOL Time Warner, Inc.," EMI Group PLe Press Release, September 22, 2003.

13 EMI Group, PLC, 2003 Annual Report, p. 14.

EM! GROup, PLC

songs of ABBA; and Our House, featuring the songs of Madness. Representative artists and songwriters in EMI Music Publishing's catalogs include Nirvana, Pink, Cliff Magness, Sean Paul, Queen, Sting, Norah Jones, Alan Jackson, and White Stripes.

EMI Operating Performance

Market Performance EMI Group PLC markets its music worldwide in nearly 50 countries. North America accounted for 32.4 percent of company sales and 26.9 percent of the company's operating profit in fiscal 2003. Continental Europe produced 30.4 percent of company sales and 34.9 percent of operating profit. The United Kingdom and Ireland represented 15.2 percent of company sales and 27.2 percent of operating profit. About 22 percent of EMI's sales and 11 percent of its operating profit came from other regions.

EMI's highest market share was in the United Kingdom and Ireland where the company had a 20.5 percent share, followed by Australasia (17 percent share) and Continental Europe (15.2 percent share). Except for Japan and Asia, EMI's market share declined in each of its regional markets during fiscal 2003. The company's worldwide market share dipped from 13.4 percent in fiscal 2002 to 12.6 percent in fiscal 2003. Exhibit 4 on page 460 shows EMI's market shares by region for 2002 and 2003.

Financial Performance EMI Group PLC recorded worldwide sales of £2,175.4 million in fiscal 2003 (one British pound £ = approximately US $1.50). Fiscal 2003 sales were 11.1 percent below fiscal 2002 sales, due mostly to a drop in recorded music sales. Operating profit for the company increased 33.1 percent between 2002 and 2003 (see Exhibit 5 on page 461).

The sales decline in recorded music reflected the worldwide slump in CD unit sales volume. The improvement in operating profit was due to a comprehensive reorganization of the EMI Recorded Music division, including a 1,900 employee reduction and ongoing efforts to reduce overhead costs and improve operating efficiency. This effort yielded positive results, particularly in the North American market for recorded music. Even though EMI's North American sales decreased 1.5 percent in fiscal 2003, operating income jumped from a loss of £2.1 million in fiscal 2002 to a £68.3 million profit in fiscal 2003. A profitable North American business in fiscal 2003 followed five consecutive years of losses for EMI in this market.

During the first half of the fiscal 2004 operating year (April 1 through September 30, 2003), EMI reported sales of£960.3 million and an operating profit of£79.7 million. Sales were unchanged from the same period the previous year. Operating profit increased 0.9 percent .

• UNIVERSAL MUSIC GROUP'S PRICING INITIATIVE

On September 3, 2003, the Universal Music Group (UMG) announced a pricing initiative designed "to reinvigorate the record business in North America."The announcement was followed by a 29-page document detailing for its retailers how the initiative would be implemented. UMG's competitors did not have access to this document. However, published interviews with retailers, UMG officials, and music industry analysts provided a general description of its contents] 4

14 This discussion is based on information from the following sources: Ethan Smith, "Universal Slashes CD Prices in Bid to Revive Music Industry," Wall Street fournal (September 4, 2003), pp. BI, B8;Jon Fine, "Universal Move Upends Music Biz," Advertising Age (September 8, 2003), pp. 3,91; Ed Christman, "Retail Pays for UMG's Price Cut; Billboard Magazine (September 13,2003), pp. 1, 68;"SeJling CDs for a Song," Newsweek (September 15,2003), p. 58; Ethan Smith, "Universal's CD Price Cuts Will Squeeze Music Retailers," Wall Street Journal (September 18,2003), pp. BI, B4; and "Sticker Price Scrapped for Universal CDs," BizReport.com, September 24, 2003.

459

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EXHIBIT 5

EMI Group, PLC Sales and Operating Profit: Fiscal 2002 and Fiscal 2003 (Year-end March 31)

Turnover (_Salesl in Millions Operating Profit in Millions'
2003£m 2002£m Change % 2003£m 2002£m Change %
Recorded music 1,774.2 2,029.4 (12.6) 150.5 83.1 81.1
Music publishing 401.2 416.4 (3.7) 103.5 107.8 (4.0)
--- --
Group total 2,175.4 2,445.8 (11.1) 254.0 190.9 33.1 • Before exceptional items and amortization of goodwiU and music copyrights. Source: EMI Group, PLe, 2003 Annual Report, p. 27.

Outline of UMG's Pricing Initiative

UMG's pricing initiative included a suggested retail price reduction, retailer display space requirements, and abolishment of retailer cooperative allowances and discounts. Each major element of UMG's initiative is described below.

Price Reduction The most publicized element of UMG's pricing initiative was the announcement that nearly all of the company's CD albums sold in North America would feature a $12.98 manufacturer's suggested retail price. Doug Morris, UMG's chairman and CEO said, "We are making a very bold, strategic move to bring people back to music stores." The CDs affected by the price cut currently carry suggested retail prices of $16.98 to $18.98. Only classical and Latin-music titles and multi-CD boxed sets, which represented a small percent of unit volume, were excluded from the price cut. According to UMG officials, the new suggested retail price was based on extensive company research indicating that a $12.98 suggested retail price was the "sweet spot" for recorded music buyers.

UMG also would reduce its CD prices to retailers. Except for superstar artist titles, UMG would lower the wholesale CD price it charges retailers to $9.09, according to Billboard Magazine. UMG's price reduction would allow retailers to price these CDs at $9.99 to consumers and make a $.90 gross profit on each CD sold. Superstar artist titles would be priced at $10.10 to retailers, but still carry a $12.98 suggested retail price. With the new pricing policy applying only to North America, UMG intended to limit retailers from exporting CDs to other countries by imposing penalties on accounts that engaged in this practice.

Jump Start Sales Plan UMG's $9.09 and $10.10 prices would be available only to retailers that adopted display space policies outlined in the company's "Jump Start" sales plan. According to industry sources, this plan required retailers to guarantee that UMG titles would be given about 27 percent of a store's display space, or 33 percent of the display space retailers used to promote the major music company's releases. UMG would also retain the right to determine which of its CDs were promoted. If some retailers elected not to guarantee display space under UMG's terms, they did not have to participate in the Jump Start program. For these retailers, CD album prices would be between $.50 and $.55 lower than UMG's current prices to retailers. Retailers were expected to notify UMG whether or not they intended to participate in the Jump Start sales program by September 19,2003.

Soon after UMG announced its Jump Start plan, UMG conceded to retailer concerns about putting the $12.98 manufacturer suggested retail price sticker on CD album packages. The original plan introduced to retailers stated that the $12.98 price would be placed on CD packages by UMG. Retailers opposed this practice for three

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reasons. First, on principle, retailers objected to having CDs delivered to them with price tags. Second, if retailers put a higher sticker price on a CD that already bad a $12.98 MSRP on it, a retailer could suffer from consumer enmity. Third, larger retailers wanted the flexibility to set CD prices below the $12.98 suggested retail price. In a September 17 letter to retailers, UMG changed its position on price stickers, stating, "While delivering a great value to the consumer is the primary goal behind]ump Start, we believe that, at this time, the goal can be reached without the MSRP"15 Instead, UMG would consider alternative CD package labeling such as "Great Music, Great Price," or "Revolutionary New Price." Following this change, UMG announced that almost all of the company's top 30 retailers in the United States agreed to provisions in the Jump Start plan by September 19, 2003. These retailers included several major chain record stores and most mass merchants.

Advertising Allowances and Discounts Whether or not retailers participated in UMG's Jump Start program, the company stated that it would eliminate all retailer cooperative advertising allowances and discounts. Cooperative advertising allowances and discounts, as a cost item, average about $.85 per CD. According to Jim Urie, president of Universal Music & Video Distribution, "Co-op advertising was a misnomer. It was money that went to the retailers, they didn't cooperate in any way." Instead, UMG officials said they intended to triple the company's media advertising expenditure with an emphasis on "artist-driven" advertising. UMG spent $4.7 million for U.S. media advertising in 2002. Sony Music Entertainment spent $8.3 million, Warner Music Group, $242,000, BMG Entertainment, $8.8 million, and EMI, $734,000.16

Initial Reaction to UMG's Pricing Initiative

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• • . ' 15 "Sticker Price Scrapped for Universal CDs," BizReport.com, September 24, 2003.

16 "AD $ Summary: Multi-Media Service, January-December 2002." CMR/Taylor Nelson Sofres u.S.

17 The following text is based on material contained in Steve Knopper, "Artists Question Cheaper CDs," RollingStone.com, September 29, 2003, and Ethan Smith, "Universal Slashes CD Prices in Bid to Revive Music Industry," Wall Street journal (September 4, 2003), pp. B1, B8.

iMI GROup, PLC

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Many specialty store merchants had relied on cooperative advertising allowances to remain profitable instead of buying advertising. Also, music company discounts were not always passed on to consumers in the form of lower retail prices for the same reason. According to an industry analyst, "The elimination of [these allowances and discounts], if it turns into an industry-wide trend, would turn barely profitable [music specialty] stores into money losers and could bury those already in trouble." In fact, some large music store chains such as Musicland, Tower Records, and Wherehouse Entertainment were already experiencing serious financial difficulties.

Some industry analysts speculated that UMG's actions could be construed as being "a grab for share in a declining marker' as much as an effort "to reinvigorate the record business in North America." Industry analysts also speculated on what the implications might be for other regions in the world if UMG's price reduction initiative in the United States was successful. Price reductions in Continental Europe and the United Kingdom could follow given UMG's market share prominence in these markets. UMG had a leading European market share of 27.3 percent in 2002 according to the Vivendi Universal 2002 Annual Report.

FORMULATING EMI'S RESPONSE TO UMG'S INITIATIVES

EM! officials needed to assess the likely impact of UMG's actions on the recorded music industry in general and how EMI's response would influence its own competitive position in the United States. IS Numerous issues had to be considered. Doug Morris, UMG's chairman and CEO, said he was hopeful that other major music companies would drop their suggested retail price as well. Industry analysts believed that all major music companies were giving this option serious consideration. At issue was the question of what EM! and other music companies would gain or lose by dropping or not dropping their suggested retail price for CDs and the price charged to retailers. UMG's retailer display requirements and decision to eliminate cooperative advertising allowances and retailer discounts warranted consideration. UMG also announced it would triple its media advertising in the United States. What was to be gained or lost by EM! and other music companies by matching these UMG initiatives in addition to the price cut? Ultimately, EMI's senior executives would need to determine the sales and profit impact and competitive consequences of whatever response they decided upon.

"Thrs discussion is based on "Universal Slashing CD Prices," Hoover's.com, September 4,2003, and Annie Lawson, "EMl Feels the Squeeze over CD Price Cuts," rnedia.guarclian.co.uk (September 5, 2003).