CD or Not CD?

Paperweights, beer coasters, and shiny rearview-mirror-hanging decorations seem to be some of the more popular uses for the compact disc these days. Pressed for sport, a music CD can also fill in for a Frisbee.  Just watch out, though. They can hurt if you miss.

Alternative uses for the CD are an important way for the format to fend off extinction these days. We're just not warming up to prerecorded-music discs the way we used to, so a CD's got to do what a CD's got to do.

Sales are off a whopping 20% so far this year, according to Nielsen SoundScan. One can write it off as an anomaly, citing a lack of anticipated releases so far in 2007, but CD sales have been dipping for seven years now.

And I am telling you I am not going
Hit CDs just aren't what they used to be. Remember when popular titles would go platinum in a couple of weeks and multi-platinum in a month or two? The days of the million-unit sellers -- much less multi-million-unit sellers -- are now few and far between. The Wall Street Journal cites some pretty disheartening data from Nielsen SoundScan, in that the Dreamgirls movie soundtrack was able to top the CD sales chart one week earlier this year despite moving just 60,000 copies. American Idol's Chris Daughtry needed just 65,000 discs to climb to the top a few weeks later.

Thankfully, digital-music sales have helped offset the avalanche. Warner Music Group (NYSE: WMG  ) punched in with $3.5 billion in revenue last year, flat with its fiscal 2005 showing. A 126% surge in digital-music sales, accounting for an 11% slice of music sales, helped stabilize the top line. More importantly, adjusted operating profits inched 18% higher for all of fiscal 2006.

Digital music is a blessing in many ways. There are no CDs to manufacture, inventory levels to stock, or retailer returns to assume once a hot record goes cold. Done right, a record company can make more money on higher-margin digital sales than old school discs. The problem is that the major labels were built to play longball. Leaner corporate infrastructures and a knack for nimbleness are the ways to go in this age of the bunt single.       

And the retailers will rock
No one is shedding a tear for the major labels. The real challenge here is at the retail level. They're the ones that suffer the most, with a 20% dip in physical product because they're not in on the higher-margin digital bounty. Several notable standalone music retailers have shuttered their doors in recent years. The survivors have been those that have evolved or were well diversified from the get-go.

Best Buy (NYSE: BBY  ) is that kind of retailer. The company never saw the CD as a high-margin item. It has been a tool that it can mark down to get shoppers into its consumer-electronics superstores to buy bigger-ticket items. Best Buy's got you even if you have a penchant for illegal downloads, thanks to its wide array of MP3 players, blank CDs, and computers.

So Best Buy has had no problem making it through the record industry's malaise with flying blue and yellow colors. It's bold. It's relevant. A few months ago, it even decided that it wanted a little more skin in the digital-downloading game. That's when it got together with SanDisk (Nasdaq: SNDK  ) and RealNetworks (Nasdaq: RNWK  ) to launch the Best Buy Digital Music Store. The combination of a SanDisk Sansa player that integrates seamlessly with a Best Buy-branded version of RealNetworks' Rhapsody music subscription service is a gutsy call, even if its chance for success is relatively slim.

The point is that the digital delivery of music today is just a prelude to the upcoming battles for the digital delivery of movies and video games. These are categories that take up plenty of shelf space at superstores like Best Buy and Circuit City (NYSE: CC  ) , so it's not a war that they can afford to take lightly.

The gall of the pallbearers
The gradual demise of the music CD is old news. Investors at this point need to turn their attention to the ramifications of the death of the CD. The DVD has been a willing pallbearer here, but is physical video the next in the casket? The ultimate irony may be that as HD-DVD and Blu-ray battle it out for platform superiority, the eventual winner will only have the luxury of watching video also migrate to digital delivery.

And then you have the video-game industry to wonder about. All three of the next-generation consoles have placed an emphasis on the Web-based connectivity of their systems. If you're GameStop (NYSE: GME  ) , do you have a response to the digital delivery of tomorrow's titles? Selling used games and gear at higher margins than the new stuff isn't going to be much of a strategy if publishers cut out the middlemen altogether.

There will be challenges. There will be opportunities. As an investor, you have to stay one step ahead of the curve. For starters, when you head out to the playground in a few years, wear thick gloves. It will be the best way to make sure that you can catch hurling CDs, DVDs, and game discs without slicing your hands. 

Here are some other stories that you can enjoy, well, digitally:

Best Buy and GameStop picks in theStock Advisor premium research service. Don't worry, you can still get a 30-day trial subscription if you want to kick those tires.   

Longtime Fool contributor Rick Munarriz is a helpless music fan, and his band was once even signed to Columbia Records. He does not own shares in any of the companies in this story. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


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