CMU Trends

Trends: Spotify – past, present and future

By | Published on Friday 2 March 2018

Spotify Press Announcement

Spotify has finally filed its paperwork with the SEC ahead of its direct listing on the New York Stock Exchange. A very long time coming indeed, the prospect of the market-leading streaming firm finally becoming a publicly-owned business, with all the extra scrutiny that comes with that status, has led to a flurry of opinion editorial pieces about Spotify in particular and the streaming music business in general.

Most of those articles sing the praises of Spotify from a consumer perspective, but then declare that streaming is bad news for artists and/or that Spotify’s business is doomed to fail. A few then propose solutions to those problems. With all that in mind CMU Trends takes a speedy look at the Spotify story to date, what the SEC filing tells us, and what the streaming company of the future might look like.

THE PAST
Spotify has arguably led the way in establishing a paid subscription model for the music industry, a fundamentally different way of doing business compared to selling physical discs or a la carte digital tracks.

When it first launched in 2008 it was by no means the first digital music start-up to experiment with the subscription – or “access” – approach. Many of the download platforms that launched in the early 2000s were also subscription-based.

Users paid a monthly subscription fee and, while their account was active, could download as many tracks as they liked from the service’s music library. However, those downloads came with digital rights management which meant that, if the user’s subscription lapsed, the downloaded tracks would stop playing.

There was much debate in the early days of digital about the pros and cons of this ‘access’ approach to downloads, where users bought access to a large catalogue of recordings, versus the ‘ownership’ approach of the iTunes Store, where users paid a fixed fee per track, but then owned their copy of said track for life.

In the download era the access model failed, and the ownership model dominated. Though that really means the ownership-based iTunes Store dominated. The fact that none of the subscription-based download services worked on Apple’s iPod, which fast became the market-leading digital music player, was definitely a factor in the failure of the plethora of subscription-based download set-ups.

This was also the era during which there was much debate about the digital rights management technology that the major record companies insisted should be embedded into every digital music file. The majors wanted DRM so that the industry could – in theory at least – control the subsequent copying and distribution of any one track after it had been downloaded by the customer.

DRM often had a negative impact on consumer experience. It also meant that no legitimate digital music platform could sell the most popular file format, the DRM-free MP3. Eventually the majors conceded that DRM didn’t really work as an anti-piracy tool and just made legal digital music services less attractive. And so DRM fell out of fashion. As did the DRM-dependent subscription download platforms.

Ironically, the offline listening functionality subsequently introduced by Spotify and the streaming services is based on exactly the same principle as those early subscription download stores – ie DRMed downloads. But by referring to this as offline listening within the context of a streaming service, no one noticed.

In much the same way that there were subscription services in the early days of digital music, there were also streaming platforms, with companies like Yahoo being particular early innovators in this space. Though dial-up internet access and slower internet connections made downloading more attractive at the outset.

Once the internet caught up and streaming became more attractive, many recognised that the ‘access’ model that had pretty much failed in the download era would likely come to dominate. It seeming to make much more sense once tracks were being streamed rather than downloaded.

Subscriptions rather than sales required a fundamentally different way of doing business on the part of the record companies and the music publishers. That alternative way of doing business evolved slowly over the 2000s.

However, it only really became relevant to the music community at large in the 2010s. At that point Spotify started to really gain momentum and the revenues being generated were significant enough that the more people needed to understand the inner workings of the business model. Which is why the Music Managers Forum commissioned CMU Insights to produce the ‘Dissecting The Digital Dollar’ reports.

Spotify wasn’t the only start-up to kickstart the second phase of the digital music revolution, facilitating the shift to streaming instead of downloads, and subscriptions instead of sales. However, it has been significantly more successful than its rivals, many of which have gone out of business, while most of those that still operate are dwarfed by the market-leader in terms of number of users.

Certainly a key factor in Spotify’s success has been the freemium-to-premium approach. Which is to say, to offer its entire catalogue to stream for free, but with ads and some limited functionality, mainly on mobile. There are plenty of critics of free streaming in the music community, and the freemium element seemed to delay Spotify’s entry into the American market, where labels were particularly resistant to the idea of all that free music being available in such a user-friendly way.

Labels in the US – and the UK to an extent – were initially resistant to the free element of Spotify because, at that time, both markets were in the middle of a significant iTunes boom. Whereas in the Nordic markets, where Spotify originated, the Apple download store never really took off. Instead, those countries went from selling CDs, to a period of massive piracy, and then straight onto streaming.

In the US and UK, where iTunes really worked for a time, there was a reasonable fear that free streaming would kill this new buoyant revenue stream. Although, however much it was booming, iTunes income never fully compensated for the continued slump in CD sales. Many argued that the download phenomenon was a mere stepping stone in the music industry’s journey from physical product to digital delivery.

For its part Spotify argued that the free level was essential to hook in consumers; so to introduce them to this new way of consuming music. From there, they could be upsold a ten pounds/dollars/euros a month subscription.

In the main, that has worked. Spotify is signing up paying users significantly faster than the vast majority of its competitors. Which brings us to now, with Spotify the biggest premium streaming service in the world by a long way.

In its SEC filing the streaming firm stated that, at the time of writing, it had 71 million paying subscribers. That is more or less double the subscriber numbers of its main competitor Apple Music, which last declared 36 million users. Apple, of course, doesn’t offer a freemium option.

THE PRESENT
So, Spotify to an extent has proven that an access-based subscription streaming service – with a freemium level to upsell premium packages – can work. It continues to out-perform all the other start-ups that have launched in this space, as well as the tech giants who have moved into music streaming.

Of course, while the Spotify-led streaming boom has been good news for the music industry, helping take the recorded music market back into growth, the streaming firm itself continues to make substantial losses. Which means it hasn’t really proven its model can work in the long-term at all. Yet.

In its SEC filing, Spotify admitted that it had built up a deficit of $3 billion due to “significant operating losses” over the last three years. And those operating losses have been rising year-on-year. An aggressive growth strategy and the corporate lifestyle of a tech start-up both contribute to Spotify’s high overheads. But it’s the company’s commitments to the music industry that constitute its biggest cost.

Spotify’s deals with the record companies, music distributors, music publishers and collecting societies are revenue share arrangements at heart. However, advances and minimum guarantee commitments means the streaming firm doesn’t get to keep the 30% of revenues it ultimately needs to become a viable concern.

It’s because of these significant losses that it’s possible to remain pessimistic about the streaming music business – and the record industry that is now so dependent on it – despite all the impressive growth figures.

In its SEC filing, which has to be upfront about the risks of the business while also presenting the firm’s sales pitch, Spotify admits that it is in a challenging business. it is a long way ahead of most of its competitors – and the high costs of market entry mean there aren’t many start-ups seeking to compete. However, tech and web giants with deep pockets could contribute to a slowdown in the growth of Spotify’s premium subscriber base. As Spotify notes, those tech and web giants in control of an app store, or the devices via which consumers increasingly access music, have a built-in advantage to exploit.

Whether or not current growth rates can be sustained and/or improved upon is really key to whether or not Spotify – and the streaming business at large – can become sustainable long-term. With the current model, streaming is a scale game. The model only works at massive scale, so that the service’s 30% is substantial, and it has the negotiating power when renewing licensing deals to ensure it is getting to keep that 30% every month. And maybe ultimately even more.

As it currently stands, only Spotify and Apple are moving anywhere near the kind of scale that is required. On the back of its Echo devices Amazon could catch up. Google could potentially become a fourth player if it can ever get its YouTube subscription service properly off the ground. But – with the exception of some local players in key emerging markets – as it currently stands those are the four companies that could potentially reach the kind of scale needed to make this model work. Notably, Spotify is the only one totally dependent on that model for its long-term survival.

Can Spotify get there? Optimists reckon it can. True, reaching the necessary scale probably requires some variable pricing, with some kind of mid-price alternative sitting between freemium and premium. But ultimately it can be achieved.

Pessimists, of course, are less certain. The best that can be said for Spotify, the pessimists might muse, is that with a record industry now so reliant on a small number of streaming services for a big share of its annual income, the market-leader is “too big to fail”. Though, relying on that assumption entirely does seem rather unwise.

THE FUTURE
There are those that believe that, for long-term profitability, Spotify cannot rely entirely on the continued growth of premium subscriptions. The company will need to find alternative revenue streams to complement the money that comes in from those who can be persuaded to pay to stream.

Advertising
Spotify already has a second revenue stream, of course. It is also in the advertising business. Ad income in theory pays for the freemium option currently enjoyed by 88 million users. And in its SEC filing, Spotify made a big deal about the potential for further growth on this side of the business.

In the very early days, Spotify did talk about its free service as being more than just an upsell platform, reckoning that free streams satisfied a different part of the market, and that a decent ad business could be built on the back of that userbase.

In the main, it has felt like the freemium level is primarily a loss-leading marketing platform, ad sales being used to set off some of those losses. Certainly that’s how many in the music industry – which receives significantly lower royalties from free streams – see it.

Although ad revenues are still dwarfed by subscription income, Spotify was keen to point out ad revenues grew 41% last year, from $359.9 million in 2016 to $507.5 million. And it is putting increased effort to generate ever more income by monetising its massive audience of free streamers.

However, as any media owner knows, internet advertising is a very competitive business that is dominated by Google and Facebook. Meanwhile, ad agencies are conditioned to value audio advertising significantly less than video advertising. Because radio advertising rates were always much lower than TV advertising rates.

There may be some opportunities to generate more ad income, possibly by shifting more into branded content. This is where big brands collaborate with media owners on creating original audio or video, which could possibly be based around Spotify’s own proprietary playlisting brands. Though that too is a very competitive market, and again spend will always be higher on video than audio, and video is yet to really take off within the Spotify ecosystem.

Hardware
As Spotify marches towards Wall Street it is also hiring people to work on new hardware projects. It’s thought the firm could be looking into launching its own voice-activated home entertainment devices.

Of course Apple famously launched the iTunes Store not to make money but to help fill the iPods it was selling with content. It was the devices themselves that were the money-makers. Though, as it turned out, the iTunes Store was pretty damn lucrative as well for a time.

Although the ‘services’ part of the tech giant’s business is actually becoming more important, you could still argue that – to an extent – Apple Music is mainly helping to sell smart phones and the company’s new HomePod. Either way, Apple certainly doesn’t need its music service to be as profitable as Spotify does in the long-term.

Hence the logic, perhaps, of Spotify also moving into hardware. Though probably not. Doing so requires going head-to-head with a number of global players with very deep pockets indeed. The idea of Spotify – to date a software company – taking a big slice of this hardware market seems optimistic.

There may be room in the market for a niche premium device that enhances the Spotify listening experience. However, it seems unlikely that this would become a major revenue stream for the company in the short or long term.

Become a content owner
There are plenty of people who have advocated Spotify becoming a content owner and signing artists and their records directly. This would weaken the negotiating hand of the major record companies, it is argued, reducing Spotify’s monthly royalty commitments. And with its privileged data and marketing channels, Spotify could find the hits of the future and license them to its rivals.

Except, if there’s one thing we know about the shift to streaming, it’s that the catalogues of old music controlled by the traditional record companies are more popular and valuable than ever. Meanwhile, signing established artists directly would be expensive. And, even with Spotify’s privileged data and marketing channels, investing in new artists would be a risky business. So, that would be Spotify trying to prop up its existing risky business by entering another risky business.

It’s true that the streaming firm may seek to populate the chill out, relaxation and generic classical playlists that have proven popular – and where artist identities are not important – with its own-generated tracks. Indeed, it’s getting to the point where AI technologies could probably automatically create this kind of music. But it seems far from assured that setting up a frontline record label would be any kind of solution to Spotify’s challenges.

Data and marketing services
Spotify currently makes a lot of data and marketing tools available to the record companies, music distributors, artists and managers. Could it ultimately sell some of these instead, generating a B2B revenue stream?

The streaming services generally see themselves as a reinvention of music retail more than anything else, and the high street retailers used to make extra cash charging record companies for prime placing in store. Could Spotify start charging for key placing within its apps or on its most popular playlists?

Monetising elements of its service that are currently editorially driven would inevitably lead to accusations of payola. If you see Spotify more as radio reinvented, that would be a legitimate complaint. Certainly Spotify would need to tread very carefully if it was to start charging for placements in places on its platform that don’t look overtly like advertising spots.

Behind-the-scenes, there may be data and marketing tools that could be developed to help labels, distributors, artists and managers which could be monetised to an extent. Though that too would likely result in some loud criticism within the music community. Not that things like that ever bothered the traditional retailers.

Direct-to-fan e-commerce
Spotify, and its rivals, have dabbled with allowing artists and their business partners to sell products beyond the music via their platforms, principally tickets and merchandise. To date most streaming services have offered this functionality for free, partly in a bid to placate those acts who moan about the royalties they receive.

That has often meant that these extra upsell functions within the streaming services have been somewhat lacklustre and in many cases hidden. But what if Spotify pushed these extra functions to the fore and then monetised them? It doesn’t make sense for Spotify to try to launch itself into ticketing or merchandise full-on, but it could start taking a small commission on any transactions on its platform.

True, those commissions would likely be tiny, meaning that for this to be a major new revenue stream Spotify would need there to be a very large number of transactions occurring across its platform each month. Though, with ticketing in particular, the total number of transactions could become significant.

Opinion is very much divided on the potential of Spotify et al becoming direct-to-fan e-commerce platforms. Increased activity in this domain would be popular among the music community though. It will be interesting to see how this side of the Spotify product continues to evolve, and whether the company will seek to monetise its e-commerce services down the line.

B2B streaming services
Finally, an area where some start-ups and Spotify itself have already dabbled, and where there is potentially a significant extra revenue stream. The provision of Spotify accounts for business users, possibly with the required public performance licences bundled in.

An increasing number of businesses are using streaming services to power the music they play in public spaces, whether shops, bars, cafes, gyms, offices or whatever. The terms and conditions of a standard Spotify subscription don’t actually allow such usage, which is where a Spotify For Business licence comes in.

There is potentially a huge market here to be tapped by a company like Spotify. This would partly require some enforcement against those companies currently using personal Spotify accounts in a business setting. But it also requires making a B2B version of Spotify really attractive to use. Bundling in the public performance licences businesses are required to get from collecting societies like PPL and PRS would also make such a product more compelling.

Growing this side of the Spotify business would require much less investment and risk, and could be incredibly lucrative relatively quickly. To that end it’s a lesser talked part of the streaming business that it would be worth the music industry itself better understanding and ultimately embracing.



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