Wherehouse Entertainment Incorporated

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Wherehouse Entertainment Incorporated

19701 Hamilton Avenue
Torrance, California 90502
U.S.A.
(310) 538-2314
Fax: (538) 538-8698

Private Company
Incorporated: 1970 as Integrity Entertainment Corporation
Employees: 7,000
Sales: $380 million
SICs: 5735 Record & Prerecorded Tape Stores; 5734
Computer & Software Stores

Wherehouse Entertainment Incorporated oversees one of the country’s largest chains of retail outlets engaged in selling audio and video recordings. Despite strong competition from industry leader Blockbuster Entertainment Corporation, the company’s stores, called The Wherehouse, have maintained a top position in its primary market, California. In fact, Wherehouse maintains over 300 stores in the western United States, the majority of which are located in California. In the early 1990s, The Wherehouse also began selling and renting video game cartridges, as well as marketing books on audio tape and used music compact discs.

Wherehouse was founded in 1970 in Gardena, California, a suburb southwest of Los Angeles, by Leon Hartstone. Hartstone named the parent company of his fledgling chain Integrity Entertainment Corporation, while the stores themselves were called The Wherehouse. The Wherehouse chain grew quickly, and at the end of its first decade in business, over 100 stores were in operation across most of its current geographical territory.

At the same time, however, Integrity Entertainment was also losing money. Thus, in 1979, Hartstone turned to Louis Kwiker, a one-time lawyer and investment banker who was then running a music industry consulting firm in Chicago. Hartstone initially hired Kwiker as a marketing and management consultant. Kwiker sold his firm, came to Los Angeles, and within a year had made such an impression on Hartstone that the company’s founder appointed him president in 1980.

Two years later, however, Hartstone died after undergoing heart surgery, and, under the terms of his will, his estate was directed to sell Integrity Entertainment’s assets for cash. Hoping to acquire the company himself, Kwiker formed an employee stock ownership trust, and, while Hartstone’s estate negotiated unsuccessfully with potential buyers, Kwiker secured a $7 million loan for the trust, enough to cover the entire purchase price of the company, from Bank of America. The trust then stepped in and acquired all of Integrity Entertainment, using its assets to secure the debt. Kwiker retained a 37 percent interest for himself, enough to maintain control of the company, and he immediately became CEO.

Under Kwiker, the company’s name was changed to Wherehouse Entertainment Corporation and headquarters were moved to the nearby suburb of Torrance. The company also embarked on a program of expansion. At the time of Hartstone’s death, The Wherehouse had 130 stores; by the end of fiscal 1985, that number had grown modestly, to 142. That year, Business Week named Wherehouse Entertainment one of the 100 best companies in the United States with annual sales of less than $150 million. Two years later, however, The Wherehouse had more than doubled in size, to 295 stores, and sales reached $225 million. At the same time, the chain proved quick to adapt to radical shifts in recording technology, phasing out long-playing records as compact discs became the wave of the future. The company also moved into sales and rental of videotaped movies, and, by 1987, it had become one of the two largest video retailers in the nation, vying with the East Coast-based Erol’s Video Club chain.

Perhaps just as impressive as its growth rate was the fact that Wherehouse Entertainment expanded dramatically while remaining relatively fussy about its choice of real estate. In order to keep up with shifts in entertainment software media, the company insisted on maintaining relatively large facilities. Therefore, unlike most chain retailers, The Wherehouse shied away from locations in regional malls, preferring sites that were either freestanding or in strip malls.

The overhead costs associated with rapid growth and higher effective tax rates began to depress company profits in 1986, and depressed stock prices left the company vulnerable to attempts at leveraged buyouts and hostile takeovers. In October 1987, Shamrock Holdings, an investment company based in the Los Angeles suburb of Burbank and headed by Roy Disney, nephew of Walt Disney, announced that it was offering $113.5 million for the 93 percent of Wherehouse Entertainment stock that it had not already acquired on the open market.

Shamrock Holdings claimed that its ownership of four television and fourteen radio stations gave it expertise that “could substantially contribute to the success of Wherehouse,” as Shamrock president Stanley Gold noted in a letter to Kwiker. Wherehouse Entertainment, however, regarded Shamrock’s bid as a hostile takeover, and, after two months of fending off Shamrock, the company turned to New York-based leveraged buyout firm Adler & Shaykin, which agreed to acquire Wherehouse Entertainment for $118 million, or $14 per share.

However, the white knight that Kwiker had courted soon proved his undoing. In March 1988, Kwiker was forced to leave the company by Adler & Shaykin. Kwiker had lately been criticized by investors for allowing the costs associated with expansion to depress company profits. Such criticism grew more intense after the company’s bondholders learned that Adler & Shaykin’s buyout package would pay them only half of the face value of their securities. In interviews Kwiker had regarded himself as a team-builder who favored the Japanese trend of consensus-based management. However, while analysts and former executives praised Kwiker as a brilliant manager, they also described him as an egotist whose management style led to conflicts with other executives.

Kwiker was replaced as CEO by Scott Young. Under Young’s management and Adler & Shaykin’s ownership, Wherehouse Entertainment realized some immediate benefits from privatization. Soon after taking over the company, Young drastically changed The Wherehouse’s merchandise mix, increasing the number of videocassettes of popular movies fourfold. The move paid off; more customers came to The Wherehouse once they realized that the chain was certain to have copies of the movies they most wanted to rent. Moreover, the move might not have occurred had the company not gone private. As Young observed: “Woe to the CEO of a publicly held company that diverges from Wall Street’s expectations, if even for a quarter…. Having only a small group of sophisticated owners made us a little more courageous.” Young also felt that privatization helped improve employee morale, since executives, spared of the need to mollify shareholders, could spend more time communicating with them.

In the long run, however, the benefits of privatization did not entirely outweigh the burden of the leveraged buyout. In the early 1990s, fiscal problems created by stiff competition from Blockbuster Video and recession in the California economy were only made worse by the high interest payments that Wherehouse Entertainment had incurred through the Adler & Shaykin buyout. Video rentals also dropped in 1991, as the nation became transfixed by the war in the Persian Gulf. Moreover, Adler & Shaykin admitted that it faced considerable problems of its own when its largest subsidiary, retail chain Best Products, filed for Chapter 11 bankruptcy in January 1991.

Not surprisingly, Adler & Shaykin were forced to sell Wherehouse Entertainment in 1992. The buyer, a group of senior management backed by Merrill Lynch Capital Partners, paid $250 million for Wherehouse, $131.4 million of which went to pay down Wherehouse’s existing debt. Merrill Lynch Capital Partners received a controlling interest in the company and hinted that it would eventually take Wherehouse Entertainment public again. Scott Young remained CEO.

However, the Merrill Lynch deal did not solve the company’s longer-term fiscal dilemma any more effectively than had the Adler & Shaykin buyout. Where Merrill Lynch’s financial package had provided $131.4 million to pay down debt, it had also created another $220 million in obligations through taking out bank loans and issuing bonds. Wherehouse Entertainment continued to lose money throughout the following year, due to continuing recession in California, competition from the Blockbuster empire, and interest payments on its long-term debt.

Looking for a way to increase sales and customer traffic, and unable to overtake Blockbuster in video rentals, the company shifted emphasis in 1993. The company’s decision to begin buying and selling used compact discs brought both opportunity and controversy. The market for second-hand music recordings had a long history, and the small stores that had always traded used records and cassettes had already started retailing used CDs. However, The Wherehouse was the largest chain to enter the business. Wherehouse had first experimented with selling used CDs in 1991, when, concerned by customer discontent over high CD prices, it began allowing customers to return CDs for full refund for any reason. Alarmed by The Wherehouse’s new policy and similar moves by other retailers, Sony’s music distribution arm stopped allowing retailers to return CDs for which the packaging had been opened. Unable to return Sony CDs, The Wherehouse instead sold them at reduced prices, much to the delight of consumers.

The market for used CDs, however, presented the music industry with a threat that used album sales never had. Second-hand records had offered consumers a trade-off: reduced price for reduced sound quality caused by wear and tear on the recording. However, CDs didn’t suffer much from use, since they required no mechanical parts, such as tape heads or phonograph needles, that grated against the recording during playback. Therefore, large quantities of good-as-new CDs could be passed between an infinite number of owners without any revenue going to the record companies or artists.

The record companies and the musicians they represented wasted little time in responding. In May 1993, the distribution arms of four of the six largest record companies—Sony, Warner Music, Capitol-EMI, and MCA—announced that they would withhold cooperative advertising money from any retailer selling used compact discs. In June of that year, country-western superstar Garth Brooks announced that he would not allow his recordings to be distributed to stores that retailed used CDs. But if, as Scott Young said at the time, the record industry giants expected Wherehouse Entertainment to retreat, they were wrong. In July, the company retaliated with a lawsuit alleging that the four major distributors had violated anti-trust laws, claiming that their refusal to provide advertising support constituted an unreasonable restraint of trade and commerce. Moreover, the suit charged that distributors were acting to protect CD prices that were “artificially high.” The Independent Retailers Music Association (IRMA) immediately voiced its support for the suit, although neither IRMA nor any of its members joined in the legal proceedings.

Whatever ill will the company may have engendered in the record industry with its lawsuit, Wherehouse Entertainment reaped a huge publicity windfall from the controversy. It also scored a significant victory in September 1993, when Capitol-EMI settled with the company, agreeing to resume cooperative advertisement. In return, Wherehouse Entertainment dropped Capitol-EMI from the suit and agreed not to sell used CDs of recordings currently being supported by cooperative ad funds.

While Capitol-EMI’s capitulation provided Wherehouse Entertainment with at least a psychological boost, it did not solve the problems presented by its substantial debt load and intense competition from major rivals in its field, which, by this time, included Blockbuster Video, Musicland, and Tower Records. Nevertheless, Wherehouse had coped well with the challenges of a retailing sector that had undergone major changes and had always managed to keep pace with its competition, if not stay a step ahead.