When 46-year-old Tower Records opted to close its doors in October, it marked the end of an era. More significantly, it marked another blow to traditional record store chains, which are dropping off the map one by one as digital files and online sales of CDs continue to gain market share.

In 2005, Tower, which operated 89 stores nationwide, was the eighth largest music retailer in the country — ranking just behind Apple's iTunes, according to Port Washington, N.Y.-based market research firm NPD Group, Inc. The year before, Tower was in seventh place and iTunes was fourteenth.

Big-box operators have also focused on music in recent years, leaving traditional record stores in a free fall. In NPD's rankings, Wal-Mart was the number one music seller in the country, based on units sold, followed by Best Buy, Target and Amazon.com. The top record store chain on the list was FYE, a unit of Trans World Entertainment, which came in fifth. Virgin Megastores didn't even make the top 10.

“I don't think traditional record stores will be able to survive over the long term,” says Phil Leigh, senior analyst with Tampa, Fla. — based Inside Digital Media, Inc. “Within the next 10 years they will be uncommon.”

With Tower disappearing, can other music retailers be far behind? Trans World posted negative revenue growth over the past five years and Virgin looks shaky. In 2004, British chain HMV gave up on the United States and closed all its stores (though it's now eyeing a comeback).

Shopping center owners are taking this as a cue to avoid record stores when leasing centers. Federal Realty Investment Trust, which has five Tower spaces, totaling 85,000 square feet, in its 17.7-million-square-foot portfolio, doesn't plan on back filling that space with another music chain.

“Cannibalization is what's happening in the music industry and we're really looking at alternative uses for Tower's spaces,” says Chris Weilminster, senior vice president of leasing with Federal. “I won't say that we'll never do business with a record store, but it would need to be a niche operator, a mom and pop store that sells vinyl.”

Music retailers now only represent 2 percent of Federal's portfolio. This is in line with the rest of the industry, where the broader category of home entertainment stores account for 5 percent of GLA.

So where will consumers go (besides online) if they want to buy CDS? A host of other retailers are looking to take up the slack. In the past year, Radio Shack, 7-Eleven and J. C. Penney Co. started selling CDs in the hope of driving up foot traffic. “Even if you are selling music to break even, it's an absolute draw for customers,” says Weilminster. “If someone picks up a CD and also ends up picking up a skirt, then it's a good business model.”

Discount retailers have also gained market share in CDs the same way they have in other segments — through low prices.

For example, Wal-Mart, Target and Virgin Megastores (through the Amazon.com website) have been selling the recently released Christina Aguilera CD Back to Basics for $11.88. But Tower Records was selling the same CD for $17.99; F.Y.E. for $14.99; and Amarillo, Texas-based Hastings Entertainment, Inc. for $15.39.

Part of the disparity in prices stems from the fact that non-music retailers generally aren't making money on the CD sales, according to Rolling Stone magazine. They see CD sales as a “loss leader” to help drive sales up in core merchandise categories.

But record stores are dependent on CDs for their livelihood and are suffering from their falling popularity and the fact that they can't afford to cut prices to match the discount sellers.

CD sales are expected to decline in 2006, from $10.52 billion, continuing a downward spiral that began five years ago, says Geoff Mayfield, director of charts and senior analyst with Billboard magazine. Meanwhile, the total dollar volume spent on downloaded singles went up by 163.3 percent in 2005, to $363.3 million. Downloaded albums brought in $135.7 million, representing a 198.5 percent increase, according to the Recording Industry Association of America (RIAA.) Together, they accounted for 6 percent of all music purchases in the United States a $12.26 billion a year business. In 2004, it was below 1 percent.

As a result, record stores have been steadily losing market share. In 1996, 49.9 percent of music purchases were made at traditional record stores. A decade later, in 2005, record stores' share had dropped to 39.4 percent. Non-music store retailers (32 percent), record clubs (8.5 percent), Internet CD sellers (8.2 percent), concerts (2.7 percent) and media outlets (2.4 percent) make up the rest of the market.

Who's left after Tower's fall

One of the most harrowing things about Tower's fall was that it was still well-regarded in the industry. For example, The National Association of Recording Merchants named the chain Retailer of the Year in the large division category for the past three years in a row.

But squeezed by online operators on one side and discount retailers on the other, Tower has been in trouble for at least two years. The retailer filed for bankruptcy in 2004, but was bailed out by its backers in exchange for an 85 percent stake in the business. When Tower filed for Chapter 11 bankruptcy again this August, it owed creditors more than $200 million.

At first, the Sacramento, Calif. — based company hoped that it would be bought by another entertainment chain. In March, it hired Houlihan Lokey Howard & Zukin to help it find a buyer and later brought in Joseph D'Amico as new CEO, whose primary responsibility was to facilitate a sale. But when Trans World Entertainment fell $2 million short of the highest bid in Tower's bankruptcy auction, national liquidation firm Great American Group snapped up its merchandise for $134.4 million. Retail Consulting Services paid $1.3 million for Tower's leases.

And Tower is not isolated in its troubles. Trans World Entertainment and Virgin Megastores are also struggling. Virgin lost approximately $495 million in the past two years. It has tried to build customer loyalty with discount cards, CD singles promotions and staff retraining, putting the emphasis on helping customers find whatever they need. Virgin also has tried to lean on non-music sales, such as its cellular phone service, apparel, books, DVDs and video games.

But Virgin still doesn't have a coherent plan for fending off online and discount competition, according to Barry Sosnick, president of Earful.info, a strategic marketing and risk management firm servicing the recorded music industry, and professor of music marketing at Five Towns College in Dix Hills, N.Y.

Meanwhile, Trans World, now with 1,107 stores, plans to increase its selection of portable DVD players, cell phones and MP3 players to help drive up revenue and shift its sales away from music and into other categories. But in 2005, 91 percent of its merchandise was still made up of music and videos. Electronics and software accessories made up the remaining 9 percent. The company has been cutting prices and buying up other record store chains to spur growth. Since 2003, Trans World acquired Camelot, Wherehouse Entertainment and CD World. In March of this year, it purchased the bankrupt Musicland chain for $122.3 million. Trans World plans to retain 335 of the chain's stores and dispose of the remaining 65.

But all this has not yet translated into solid results. Last year, it posted $1.24 billion in sales, down from $1.37 billion in 2004.

“We think the long-term outlook for this company is dismal,” writes Morningstar analyst Joseph Beaulieu. “Sales have declined over the past five years, same-store sales growth has also been dismal and sales per square foot continue to fall.”

Hastings Entertainment, which operates 153 stores, has done better by mixing up its offerings. Only 25 percent of its sales come from music; the rest comes from books (22 percent), video (19 percent), rentals (17 percent) and miscellaneous other products. With the exception of 2004, the company increased revenue in the past five years, posting $537.9 million in 2005. Hastings plans to open two new stores this year.

Sosnick has noted that some entertainment chains, including Hastings, recently started offering coffee to their customers. “A lot of the independents are doing more soft goods — tee shirts, posters, believe it or not, drug paraphernalia,” he says. “You have them trying to move from being music stores to becoming lifestyle merchants.”

Two markets for music

“You have two markets for music,” says Sosnick. “The hit driven market, where most of the sales are made on an impulse basis, is dominated by Wal-Mart and Best Buy because they have the low prices and the necessary foot traffic.”

The other market is catalogue sales, made up of older titles and niche products that consumers are willing to pay higher prices for. “The larger record stores — Virgin, Tower, HMV — are facing a tough battle because their point of differentiation had been the catalogue sales and they have been hit the hardest by online,” Sosnick says.

In order to stay in business, traditional music stores will have to get creative, says Leigh. One possibility involves moving toward customized CDs, with prospective buyers choosing songs from different albums to create a one-of-a-kind product.

The prototype for this kind of service would be Starbucks' Hear Music division, which lets customers burn their own CDs at coffeehouses in Seattle, Wash., Austin, Texas and Santa Monica, Calif. The coffee chain also sells exclusive CDs, including music from Ray Charles and Bob Dylan. But for Starbucks, the goal in these ventures is to keep people in the store for a longer period of time rather than sell more CDs.

But Sosnick doesn't think this is a viable long-term solution for record stores. “When it comes to customized CDs they have only a few kiosks in the store and people tend to stay in them for a long time.” Sosnick says.

Adapting online

The iTunes outfit is one of the most formidable threats facing the record store industry. Its prices (99 cents a song), the convenience of shopping from home and the cult of the iPod, all contribute to iTunes' brand recognition.

Virgin has been trying to compete with iTunes by launching Virgin Digital, which offers song-by-song downloads for 99 cents, and most record chains now have web sites through which customers can purchase CDs.

But with iPods claiming 61 percent of the MP3 player marketplace, according to a Consumer Behavior report published by PriceGrabber.com in April, Apple is a tough opponent.

MP3 devices produced by other manufacturers represented only 39 percent of the market when combined. Microsoft has now entered the picture with its Zune player, but the jury is out on how the device will fare.

At same time, discount retailers have been making inroads into the download niche as well — Wal-Mart is currently selling songs at 88 cents apiece, although its files are not compatible with iPods.

In the end, there are few strategies record stores can adopt to fend off the online competition, Sosnick says. That means that the remaining chains are only forestalling the inevitable with their various strategies. Ultimately, Tower's fate is what awaits all the traditional music chains. It's simply a matter of time.

2005 CONSUMER PROFILE
Format 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Full-length CDs 68.4% 70.2% 74.8% 83.2% 89.3% 89.2% 90.5% 87.8% 90.3% 87.0%
Full-length Cassettes 19.3 18.2 14.8 8.0 4.9 3.4 2.4 2.2 1.7 1.1
Singles 9.3 9.3 6.8 5.4 2.5 2.4 1.9 2.4 2.4 2.7
Videos/DVDs 1.0 0.6 1.0 0.9 0.8 1.1 0.7 0.6 1.0 0.7
DVD audio N/A N/A N/A N/A N/A 1.1 1.3 2.7 1.7 0.8
Digital Download N/A N/A N/A N/A N/A 0.2 0.5 1.3 0.9 5.7
SACD* N/A N/A N/A N/A N/A N/A N/A 0.5 0.8 1.2
Vinyl LPs 0.6 0.7 0.7 0.5 0.5 0.6 0.7 0.5 0.9 0.7
Channel
Record Store 49.9 51.8 50.8 44.5 42.4 42.5 36.8 33.2 32.5 39.4
Other Store 31.5 31.9 34.4 38.3 40.8 42.4 50.7 52.8 53.8 32.0
Record Club 14.3 11.6 9.0 7.9 7.6 6.1 4.0 4.1 4.4 8.5
TV, Print Media As 2.9 2.7 2.9 2.5 2.4 3.0 2.0 1.5 1.7 2.4
Internet N/A 0.3 1.1 2.4 3.2 2.9 3.4 5.0 5.9 8.2
Digital Download N/A N/A N/A N/A N/A N/A N/A N/A N/A 6.0
Concert N/A N/A N/A N/A N/A N/A N/A N/A 1.6 2.7
* SACD — Super Audio CD
Source: Recording Industry Association of America