Spotify’s Tencent Risk

NOTE: a previous version of this post referred to a non-compete clause with Spotify detailed in this SEC filing. I have been advised that the scope of this clause is narrower than I had originally interpreted. I have therefore updated this post to remove reference to that clause but the essence of the post remains intact due to the potential role of the major labels which, as outlined below, could have the same effect as a non-compete clause.

On Thursday (September 20th) Spotify grabbed the headlines with its announcement that it is launching a free-to-use direct upload service for artists. While it is undoubtedly a big move, and one that will concern Soundcloud among others, it was not a surprising move. In fact, in April we predicted this would happen soon:“Spotify will take a subtler path to ‘doing a Netflix’, first by ‘doing a Soundcloud’, i.e. becoming a direct platform for artists and then switching on monetisation”. Will labels be concerned, sure, because although Spotify might not be parking its tanks on their lawn yet, it is certainly slowly reversing them in that general direction. However, they may just have a way of clipping Spotify’s wings and waiting in, er, the wings…Tencent.

Still waiting for IPO metrics

Tencent is prepping its music division (TME) for a partial US IPO but announced earlier this week that it will be reducing the amount it is seeking to raise from $4 billion to $2 billion, though still against a reported valuation of around $25 billion. Regular readers will know I have a healthy scepticism of Tencent’s music numbers. It has only ever reported one subscriber number officially – 4.7 million for QQ Music in Q1 2016, therefore it has plausible deniability over all the non-official numbers it puts out via the press. So, the fact there still isn’t an F1 filing revealing TME’s metrics is intriguing to say the least.

Go west

The likelihood is that the numbers will show a relative flattening in music subscriber growth (though other areas of its business should be robust). If so, they fit a wider narrative of Tencent nearing the limits of its potential in China. Video subs, which have grown superfast, will soon slow, messaging is saturated and the Chinese government is curtailing Tencent’s games operations. The title of our April report says it all: “Tencent Has Outgrown China: Now Comes the Next Phase of Growth”. Until last year’s change in Chinese regulations, Tencent could quite happily have spent its time strolling across the globe buying up companies to spread its global wings. But now, operating under limits of how much it can spend on overseas companies, Tencent is restricted to taking minority stakes in companies like Gaana and Spotify. But those efforts do not deliver Tencent the scale of global growth it needs. You can probably see where this is heading: to grow its music business TME will have to roll out internationally, which is quite possibly part of the story it will use to justify its $25 billion valuation.

Ring fencing Spotify’s global reach 

Should TME decide to use the $2 billion it raises via IPO as a war chest, it could then go on a global roll out to all the markets where Spotify is currently not present. Getting their first, with the backing of Tencent and of the $2bn IPO windfall would put Spotify on the back foot. Especially if, and here’s the crucial part, the major record labels took this as an opportunity to knock Spotify down a peg because of its increasingly competitive behaviour. They’ve been relying on Indian licenses already, that could prove to be a template, with Tencent the grateful beneficiary.  This would have the effect of ring-fencing Spotify’s global roll out plans. For fans of the board game Risk, the board would look something like this:

Spotify tencent risk 1

But Risk’s map doesn’t really do it justice. Using a political global map, the respective footprints would look more like this:

Spotify tencent risk 2

The major labels have proven unwilling to license Spotify for India because they weren’t happy with Spotify offering direct deals for a small number of artists. Imagine how they are going to feel with this latest move. With TME waiting patiently on the side lines, they may just see it as an opportunity to carve up the global streaming landscape into two halves, creating a cold war stalemate. Your move Spotify.

Mid-Year 2018 Streaming Market Shares

Music subscribers grew by 16% in the first half of 2018 to reach 229.5 million, up from 198.6 million at the end of 2017. Year-on-year the global subscriber base increased by 38%, adding 62.8 million subscribers. This represents strong but sustained, rather than strongly accelerating, growth: 60.8 million net new subscribers were added between H1 2016 and H1 2017. This indicates that subscriber growth remains on the faster-growth midpoint of the S-curve. MIDiA maintains its viewpoint that this growth phase will last through the remainder of 2018 and likely until mid-2019.

midia mid year 2018 subscriber mareket shares

This will be the stage at which the early-follower segments will be tapped out in developed markets. Thereafter, growth will be driven by mid-tier streaming markets such as Japan, Germany, Brazil, Mexico, and Russia. These markets have the potential to drive strong subscriber growth, but, in the case of the latter three, will require aggressive pursuit of mid- tier products – including cut-price prepay telco bundles, as seen in Brazil. Without this approach, the opportunity will be constrained to the affluent, urban elites that have post-pay data plans and credit cards. These sorts of products though, will of course deliver lower ARPU in already lower ARPU markets. All of this means: expect revenue to grow more slowly than subscribers from mid 2019.

The key service-level trends were:

  • Spotify:Spotify once again maintained global market share of 36%, the same as in Q4 2017, with 83 million subscribers. Spotify has either gained or maintained market share every six months since Q4 2016. Spotify added more subscribers than any other service in H1 2018 – 11.9, which was 39% of all net new subscribers across the globe in the period.
  • Apple Music:Apple added two points of market share, up to 19%, and up three points year-on-year, with 43.5 million subscribers. Apple Music added the second highest number of subscribers – 9.2 million, with the US being the key growth market.
  • Amazon:Across Prime Music and Music Unlimited Amazon added just under half a point of market share, stable at 12%. Amazon experienced the most growth within its Unlimited tier, adding 3.3 million to reach 9.5 million in H2 2018. In total Amazon had 27.9 million subscribers at the end of the period.
  • Others:There were mixed fortunes among the rest of the pack. In Japan, Line Music experienced solid quarterly growth to reach one million subscribers, while in South Korea MelOn had a dip in Q1 but recovered in Q2 to finish slightly above its Q4 2017 figure. Elsewhere, Pandora had a solid six months, adding 0.5 million subscribers, while Google performed strongly on a global basis

The mid-term report card for the music subscriptions market in 2018 is strong, sustained growth with a similar second half of the year to come.

How Streaming is Changing the Shape of Music Itself [Part I]

[This is the first of two thought pieces on how streaming is reshaping music from creation to consumption] 

The streaming era has arrived in the music business, but the music business has not yet fully arrived in the streaming era. Labels, publishers, artists, songwriters and managers are all feeling – to differing degrees – the revenue impact of a booming streaming sector. However, few of these streaming migrants are fundamentally reinventing their approach to meet the demands of the new world. A new rule book is needed, and for that we need to know which of today’s trends are the markers for the future. This sort of future gazing requires us to avoid the temptation of looking at the player with the ball, but instead look for who the ball is going to be passed to.

Where we are now

These are changes that represent the start of the long-term fundamental shifts that will ultimately evolve into the future of the music business:

  • A+R strategy: Record labels are chasing the numbers, building A+R and marketing strategies geared for streaming. The bug in the machine is the ‘known unknown’ of the impact of lean-back listening, people listening to a song because it is in a pushed playlist rather than seeking it out themselves. Are labels signing the artists that music fans or that data thinks they want?
  • Composition:Songwriters are chasing the numbers too. The fear of not getting beyond the 30 second skip sees songs overloaded with hooks and familiar references. The industrialisation of song writing among writing teams and camps creates songs that resemble a loosely stitched succession of different hooks. Chasing specific playlists and trying to ‘sound like Spotify’delivers results but at the expense of the art.
  • Genre commodification:The race for the sonic centre ground is driving a commodification of genres. The pop music centre ground bleeding ever further outwards, with shameless cultural appropriating par for the course. Genres were once a badge of cultural identity, now they are simply playlist titles.
  • Decline of the album:iTunes kicked off the dismembering of the album, allowing users to cherry pick the killer tracks and skip the filler. The rise of the playlist has accentuated the shift. Over half of consumers aged 16–34 are listening to albums less in favour of playlists. The playlist juggernaut does not care for carefully constructed album narratives, nor, increasingly, do music listeners.
  • Restructuring label economics:Achieving cut though for a single takes pretty much the same effort as for an album. So, it is understandable that label economics still gravitate around the album. But streaming is rapidly falsifying the ROI assumption for many genres, with it being the tracks, not the albums that deliver the returns in these genres.
  • Decline of catalogue:Streaming’s fetishisation of the new, coupled with Gen Z’s surplus of content tailored for them, deprioritises the desire to look back. Catalogue – especially deep catalogue, will have to fight a fierce rear-guard action to retain relevance in the data-driven world of streaming.
  • Audience fragmentation: Hyper targeting is reshaping marketing and music is no different. While the mainstream of A+R chases the centre ground, indies, DIY artists and others chase niches are becoming increasingly fragmented. Yet, most often, this is not a genuine fragmentation of scenes, but an unintended manifestation of hyper- focused targeting and positioning.
  • End of the breakthrough artist:Fewer artists are breaking through to global success. None of the top ten selling US albums in 2017 were debut albums, just one was in the UK. Just 30% of Spotify’s most streamed artists in 2017 released their first album in the prior five years. Streaming’s superstars – Drake, Sheeran etc. – pre-date streaming’s peak. Who will be selling out the stadium tours five years from now?
  • Massively social artists:Artists have long known the value of getting close to their audiences. Social media is central to media consumption and discovery, and its metrics are success currency. Little wonder that a certain breed of artist may appear more concerned with keeping their social audiences happy than driving streams.
  • Value chain conflict:BuzzFeed’s Jonah Peretti once said “content may still be king but distribution is the queen and she wears the trousers”. Labels fear Spotify is out to eat their lunch, Spotify fears labels want to trim its wings. Such tensions will persist as the music industry value chain reshapes to reflect the shifts in where value and power reside.

Next week: where these trends will go.

To paraphrase Roy Amara:“It is easy to overestimate the near-term impact of technology and underestimate the long-term impact.”

What Netflix’s Missing $9 Billion Tells Us About Spotify’s Business Model

On Monday (July 16th), Netflix’s quarterly earnings missed targets, resulting in $9.1 billion being wiped off its market capitalisation due to twitchy investors jumping ship. To be clear, Netflix had a strong quarter, continuing to grow strongly in both the US – a much more saturated market for video subscriptions than for music – and internationally. Netflix also registered a net operating profit. What it failed to do was meet the ambitious expectations it had set. The lessons for Spotify are clear. With Spotify’s Q2 earnings due later this month, it will be bracing itself for another potential drop in stock value if its performanceis good but not good enough to keep ambitious investors happy. Such is the life of a publicly traded tech company.

But perhaps the most telling part of Netflix’s stock performance was that the $9.1 billion of market cap it lost is more than a quarter of Spotify’s entire market cap ($33.3 billion on Tuesday). Netflix of course plays in a much bigger market than Spotify: the US video subscription market will be worth $17.3 billion in 2018—the same amount that the IFPI estimates the entire global recorded music business generated in 2017. But, the perspective is crucial. Lots of institutional investment has flowed into Spotify since it went public – and indeed prior to that, but music is a tiny part of those investors’ portfolio. Netflix’s loss in market cap shows that even the golden child of streaming does not deliver enough promise for many of those investors, but investors have plenty of other TV industry bets to make if they abandon Netflix. For music, institutional investors basically have Spotify or Vivendi. So, while Netflix struggling is a problem for Netflix, a struggling Spotify would be a problem for the entire recorded music business.

Savvy switchers – Netflix’s churn problem

Netflix’s earnings also present some positive signs for the strength of Spotify’s business model compared to Netflix’s, such as its growing quarterly churn rate: around 8% in Q2 2018, up from 6% the prior quarter. This reflects what my colleague Tim Mulligan refers to as ‘savvy switchers’– video subscribers who churn in and out of services when there’s a new show to watch. This is a dynamic unique to video, created by the walled garden approach of exclusives. No such problem faces Spotify, for now at least, because all of its competitors have largely the same catalogue.

Content spend: uncapped versus fixed

Most relevant though, is Netflix’s content spend. One of the much-used arguments against Spotify in favour of Netflix is that Spotify has fixed content costs, hindering its ability to increase profits, because costs will always scale with revenue. However, Spotify’s advantage is in fact that content costs are fixed, there is a cap on how much it will spend on rights. Netflix has no such safeguard, which means that the more competitive its marketplace gets, the more it has to spend on content.

This is why Netflix has had to take on successive amounts of debt – accruing to $9.7 billion since 2013. Servicing this debt cost Netflix $318.8 million for the 12 months to Q2 2018, one year earlier the cost was $181.4 million. For the 12 months to Q2 2018, Netflix’s streaming content liabilities were $10.8 billion, representing 80% of streaming revenues, which compares favourably with Spotify’s 78%. One year earlier, those liabilities for Netflix were $9.6 billion, representing a whopping 99% of streaming revenues. The reason Netflix can do this and generate a net margin is that it amortises the costs of its originals (essentially offsetting some of its tax bill). For the 12 months to Q2 2018 Netflix amortised 64% of its content liabilities, one year earlier that share was 57%, reflecting originals being a larger share of content spend during 12 months to Q2 2018. The more originals Netflix makes, the more it can increase its margin. Which creates the intriguing dynamic of the US Treasury subsidising Netflix’s business model. Welcome to the next generation of state funded broadcaster!

Q2 will tell

Spotify spending billions on original content is some way off yet – assuming it engineers a way to do so without antagonising its label partners, but until then it can rest assured that while Netflix faces growing content costs, it has its exposure capped, allowing it to focus on growing its customer base and enhancing its product. The reaction to the forthcoming Q2 earnings will show us whether investors see it that way too.

Spotify’s New Rules of Engagement

It is easy to feel that the pervasive obsession with Spotify overplays its importance to the recorded music industry. On the one hand it may only represent 27% of global recorded music revenues, but this compares to a peak of around 10% that Apple enjoyed at the peak of the iTunes Music Store. So, whatever label concerns existed back then about market influence – and there were plenty – their apprehensions have now multiplied. The assumption among many investors and label executives is that Spotify’s market share will lessen as the market grows. However, Spotify has thus far held onto its subscriber market share as the market has grown and looks set to do so in the foreseeable future.

If revenue is Spotify’s ‘hard power’ its real influence comes in its ‘soft power’. This takes two key forms:

  • Cultural influence:Despite being less than a third of revenues, record labels, artists and managers typically see Spotify as the proving ground, the place where hits are made. Marketing and promotion efforts are centred around getting traction on Spotify, knowing that success there normally leads to success elsewhere. Thus, Spotify’s cultural influence far outweighs its market share. As is so often the case with soft power, those affected most by it are those who inadvertently ceded it.
  • Innovation / disruption / innovation:Since embarking on its DPO path Spotify has been talking out of both sides of its mouth at the same time. On the one hand it positions itself as a safe pair of hands for the records labels, and on the other it lays out for investors a vision of a future world were artists don’t have to choose to work with labels. Labels have long feared just how far Spotify is willing to go and also, just how quickly. Spotify is now showing signs of going full tilt.

 

A rabbit out of the hat

When Spotify reported its Q1 earnings, the music industry consensus was a job well done. It delivered nearly on-target revenues (though they were down slightly on Q4), solid subscriber growth, improved margins and reduced churn. But it wasn’t enough for Wall Street. Spotify’s stock price fell to $150.07 down from a high of $170 in the days building up to the earnings. So what went wrong? Investors were expecting Spotify to pull a rabbit out of the hat. They’d been promised an industry changing investment and had instead got an industry sustaining investment. Such fickle investor confidence so early on in the history of a public company can be fatal. So, Spotify quickly searched for that rabbit; it announced that it will do direct deals with some artists and managers. Guess what happened? Spotify’s stock price rose to $172.37. The rabbit was bounding across the stage.

Untitled

Investors want the new world now

These are the new rules of streaming music. As the bellwether of streaming, Spotify has been dictating the narrative for years, but always with the focus of being a partner for rights holders. Now that it is public, Spotify has found that tough talking trumps sweet talking. Even if Spotify does not intend to go fast on its next gen-label strategy, it now knows it has to talk fast. Speaking from the experience of months of deep conversations with large institutional investors, Wall Street has pumped money into Spotify stock not because of how it will help labels’ businesses, but because they expect it to replace labels, or, at the very least, compete with them at scale. Spotify’s stock was not cheap, so to deliver to investors the returns they crave, it has to show that its influence is as disruptive / innovative (delete depending on your perspective) for the music business as Netflix has been for the TV business. They are investing in the potential upside on a future industry changer, not a present-day industry defender.

Spotify needs to speak boldly but act responsibly

Spotify cannot of course go all guns blazing yet, as it simply cannot afford to operate without the major labels. Netflix could get away with what it did because the TV rights landscape is fragmented. Therefore, Spotify will have to tread carefully until it can pick away at major label market share through various forms of direct deals. But it also has to do this cautiously (as I explained in this post). If it is too quick and bold it will incite retaliatory action from the labels. So, the new rules of engagement for Spotify and rights holders are a bit like international diplomacy: make bold public statements to keep domestic voters happy but adopt a more conciliatory approach with partners behind closed doors. Let’s just hope that Spotify opts for the Justin Trudeau school of international diplomacy over the Donald Trump approach.

Spotify’s Censorship Crisis is About Social Responsibility

Spotify has been forced into something of a rethink regarding its hate speech policy. Spotify announced it was removing music from playlists of artists that do not meet its new policy regarding hate speech and hateful behaviour. R.Kelly, who faces allegations of sexual abuseand XXXTentacion, who is charged with battering a pregnant woman, were two artists that found their music removed. Now Spotify is softening its stance following push back externally and internally, including from Troy Carter who made it known that he was willing to walk away from the company if the policy remained unchanged. Spotify had good intentions but did not execute well. However, this forms part of a much bigger issue of the changing of the guard of media’s gatekeepers.

Facebook has been here before

Back in late 2016, Facebook faced widespread criticism for censoring a historic photograph of the Vietnam warin which a traumatised child is shown running, naked, away from a US napalm attack. Facebook soon backed downbut it got to the heart of why the “we’re just a platform” argument from the world’s new media gatekeepers was no longer fit for purpose. Indeed by the end of the year, Zuckerberg had all but admitted that Facebook was now a media company.The gatekeepers might be changing from newspaper editors, radio DJs, music, film and TV critics and TV presenters, but they are still gatekeepers. And gatekeepers have a responsibility.

Social responsibility didn’t disappear with the internet

Part of the founding mythology of the internet was that the old rules don’t apply anymore. Some don’t, but many do. Responsibilities to society still exist. Platforms are never neutral. The code upon which they are built have the ideological and corporate DNA of their founders built into them – even if they are unconscious biases, though, normally, they are anything but unconscious. The new gatekeepers may rely on algorithms more than they do human editors, but they still fundamentally have an editorial role to play, as the whole Russian election meddling debacle highlighted. Whether they do so of their own volition or because of legislative intervention, tech companies with media influence have an editorial responsibility. Spotify’s censorship crisis is just one part of this emerging narrative.

Editorial, not censorship

As with all such debates, language can distort the debate. Indeed, the term ‘censorship’ conjures up images of Goebbels,but swap the term for ‘editorial decisions’ and the issue instantly assumes a different complexion. Spotify was trying to get ahead of the issue, showing it could police itself before there were calls for it to do so. Unfortunately, by making editorial decisions based upon accusations, Spotify made itself vulnerable to being accused of playing the role of judge and jury for artists who live in countries where innocence is presumed in legal process, not guilt. Also, by implementing on a piecemeal rather than exhaustive basis, it gave itself the appearance of selecting which artists’ misdemeanours were considered serious enough to take action upon. Spotify had the additional, highly sensitive, risk of appearing to be a largely white company deselecting largely black artists on playlists. Even if neither semblance was reflective of intent, the appearance of intent was incendiary.

Lyrics can be the decider

Now Spotify is having to rethink its approach. It would be as wrong for Spotify to opt for the ‘neutral platform’ approach as it would be ‘arbitrary censorship’. An editorial role is necessary. In just the same way radio broadcasters are expected to filter out hate speech, tech companies have a proactive role to play. A safer route for Spotify to follow, at least in the near term, would be to work with its Echo Nest division and a lyrics provider like LyricFind to build technology, moderated by humans, that can identify hate speech within lyrics and song titles. It wouldn’t be an easy task, but it would certainly be an invaluable one, and one that would give Spotify a clear moral leadership role. In today’s world of media industry misogyny and mass shootings, there is no place for songs that incite hatred, racism, sexism, homophobia or that glorify gun violence. Spotify can take the lead in ensuring that such songs do not get pushed to listeners, and thus start to break the cycle of hatred.

Is YouTube Serious About Music Subscriptions This Time Round?

In 2014 YouTube launched its inaugural music subscription service YouTube Music Keyin beta. The following year YouTube announced it was closing it ahead of the launch of YouTube Red, a multi-format subscription video on demand (SVOD) offering, of which music was going to be sub-component. Soon after Music Key’s launch I announced on stage at a Mixcloud Curates event that it would close within two years: and

I’m gonna put my cards on the table and say it [YouTube Music Key] won’t exist in 18-24 months after

Now YouTube is backfor another round at the table with the launch of YouTube Music.

In 2014 my Nostradamusmoment was less about being a psychic octopusthan it was simply a case of joining the strategic dots. YouTube is all about advertising. Advertisers pay most to reach the best consumers, who are also the ones most likely to pay for a subscription service, which is ad free. YouTube’s ad business is high margin and large scale. Its music subscription business is low margin and low scale. Hence, the more successful YouTube’s music subscription business is, the more harm it does to its core business and operating margins. The same principles apply today as they did four years ago.

So why bother at all? Because it has to keep the labels on side. Although the labels scored a lobbying own goal with their Facebook music deal, they are still applying pressure on YouTube for its safe harbour framework and the ‘value gap’. So if YouTube does not play ball on premium, it puts its core ad business at risk. And music is still the largest single source of YouTube’s ad revenue. Total YouTube ad revenue was $9.6 billion in 2017 – that is a revenue stream that parent company Alphabet cannot put at risk.

youtube spotify.png

When YouTube launched Music Key it used those negotiations to get better features for the free YouTube music offering, including full album playlists, which went live the day after the deal was announced and are still there now, even though Music Key is not. YouTube is no slouch when it comes to doing deals. This time however, YouTube Music will last longer. Here’s why:

  • This isn’t actually year zero:Google already has around five million Play Music subscribers and around the same number of YouTube Red subscribers. Red subscribers will become YouTube Premium subscribers, Play Music subscribers will get access to YouTube Music. So, inasmuch as YouTube is launching a cool new app with lots of new features, this is not Google entering the streaming fray, it is simply upping its game.
  • Spotify is making up ground:YouTube Music is not about to become the global leader in music subscriptions, for all the above stated reasons and more, but it can’t stand on the side lines either. Data from MIDiA’s Quarterly Brand Tracker shows that while YouTube is still the leading streaming music app in weekly active user (WAU) terms, Spotify is making up ground. Crucially, Spotify is now more widely used (for music) among 16–19 year olds. And Spotify is betting big on ad-supported, largely because it has finally persuaded the labels and publishers to amend its deals to allow it to, evidenced by the fact that Q1 2018 ad-supported gross margin increased dramatically from -18% to 13% in Q1 2017. YouTube Music is in part a defensive play to ensure it has an enriched offering for thoseconsumers, both now as free users, and for when they want to pay.
  • YouTube is the best featured music service: One of the great ironies of the recorded music industry’s relationship with YouTube is that because it doesn’t have to negotiate deals in the way other services to, it now has the best featured music service. Streaming and social have risen in tandem, but only YouTube has fully embraced this with comments, likes / dislikes, mash ups, user cover versions, parodies, unofficial remixes etc. And all of these features are front and centre in the new service. Spotify and co can’t get that sort of content because the labels can’t license it. Moreover, labels don’t like users being able to thumb down their songs or comment negatively on them. This launch enables YouTube to shout from the roof top about what it has and, by inference, what Spotify does not.
  • Testing:YouTube Music is being rolled out in the same markets as YouTube Red was (US, Australia, New Zealand, Mexico and South Korea). This slightly eclectic mix of markets represent a test base; a wide range of varied markets that will provide diverse user data to enable YouTube to model what global adoption will look like.
  • Upping the ad load: YouTube’s global head of music Lyor Cohen has nailed his colours firmly to the subscription mast. Although Cohen may not be up high in the Alphabet hierarchy he is a strong voice in YouTube’s music business. It also serves Alphabet well to have this particular voice with that sort of message at the forefront. Cohen has gone on record stating that YouTube will up its ad load to force more users to paid, and it is happening, but it is not just a music thing. Ad loads are up across the board on YouTube. Either way, this element was patently missing back in the days of Music Key.

YouTube Music may not be the start of Alphabet’s streaming game, but it is certainly its biggest play yet. And while it will remain focused on protecting its core business, it will likely explore ways to drive ad revenue within its ‘ad free’ premium offerings. Sponsorship and product placement will be one tactic; using MirriAd’s dynamic product placement ad tech could be another. YouTube is unlikely to become the leading music subscription service soon, but there is no denying that it has clearly upped its game.

The data in this chart and some of the analysis will form part of MIDiA’s forthcoming second edition of its landmark ‘State of the YouTube Music Nation’ report. If you are not already a MIDiA client and would like to know how to get access to this report and data, email stephen@midiaresearch.com

Could Spotify Buy Universal? 

Vivendi is reported to be proposing to its board a plan for spinning out Universal Music. It is certainly the right time for a spin off (always sell before the peak), but a full divestment would leave Vivendi unbalanced and a shell of its former self. Canal+ is facing the same Netflix-inspired cord-cutting pains as other pay-TV operators (and is relying heavily on sub-Saharan Africa for subscriber growth), while other assets such as those in Vivendi Village have failed to deliver. With CEO Vincent Bolloré having invested heavily in Vivendi, he would be devaluing his own wealth. For a man who is not shy of saying that he’s in the game to make money, this scenario simply doesn’t add up. As one investment specialist recently suggested to me, this talk of a spin-off is probably exactly that, talk. Talk aimed at driving up Vivendi’s valuation by association and, at most, potentially resulting in a partial spin-off or partial listing. However, it is not beyond the realms of possibility that a big enough offer for Universal would persuade Bolloré to sell. So, let’s for a moment assume that Universal is on the market and have a little fun with who could buy it.

The Chinese option

It is widely rumoured that Alibaba was in advanced discussions with Vivendi to buy some size of stake in Universal. Those conversations derailed when the Chinese government tightened up regulations on Chinese companies buying overseas assets, which is why we now see Tencent buying a growing number of minority stakes in companies rather than outright acquisitions. So, an outright Chinese acquisition is likely off the table. This doesn’t rule out other Asian bidders (Softbank had an $8.5 billion bid rejected in 2013), though perhaps Chinese companies are the only ones with the requisite scale and access to cash that would meet a far, far higher 2018 price point.

The tech major option

The most likely scenario (if Universal were for sale) is that one of the tech majors (Apple, Alphabet, Amazon, Facebook) swoops in. Given Google’s long-held antipathy for the traditional copyright regime, Alphabet is not the most likely, while Facebook is too early in its music journey (though check back in 18 months if all goes well). Apple and Amazon are different cases entirely. Both companies are run by teams of older executives whose formative cultural reference points were shaped by traditional media companies. These are companies that, even if they may not state it, see themselves as the natural evolution of media, moving it from the physical era of transactions to the digital era of access. Thus far, Apple and Amazon have focused principally on distribution, although both have invested in rights too. Apple less so, (e.g. Frank Ocean, Chance the Rapper) but Amazon much more so (e.g. Man in the High Castle, Manchester by the Sea). Acquiring a major media company is a logical next step for Amazon. A TV studio and, or network would likely be the first move (especially as Netflix will likely buy one first, forcing Amazon’s hand), but a record label wouldn’t be inconceivable. And it would have to be a big label – such as UMG, that would guarantee enough share of ear to generate ROI. Apple though, could well buy a sports league, which would use up its budget.

The Spotify option

While the tech majors are more likely long-term buyers of Universal, Spotify arguably needs it more (and is certainly less distracted by other media formats). Right now, Spotify has a prisoner’s dilemma; it knows it needs to make disruptive changes to its business model if it is going to create the step change investors clearly want (look at what happened to Spotify’s stock price despite an impressive enough set of Q1 results). But it also knows that making such changes too quickly could result in labels pulling content, which would destroy its present in the hope of building a future. Meanwhile, labels are worried Spotify is going to disintermediate them but can’t risk damaging their business by withdrawing content now – hence the prisoner’s dilemma. Neither side dares make the first move.

That’s the problem with the ‘do a Netflix’ argument: do it too fast and the whole edifice comes tumbling down. Moreover, original content will not be the same silver bullet for Spotify as it was for Netflix. This is mainly because there is a far smaller catalogue of TV content than music, so a dollar spent on original video goes a lot further than a dollar spent on original music. It is not beyond the realm of possibility that Spotify will get to a tipping point, where the labels see a shiny-toothed wolf lurking under the lamb’s wool, and with its cover blown it will be forced to go nuclear. If this happened, buying a major label would become an option. And, as with the tech majors, it would have to be a major label to deliver enough share of ear.

But that scenario is a long, long way off. First, Spotify has to prove it can be successful and generate enough revenue and market cap to put itself in a position where it could buy a major. And that is still far from a clear path. For now, Spotify’s focus is on being a partner to the labels, not a parent company.

All of this talk might sound outlandish but it was not so long ago that an internet company (AOL) co-owned Warner Music and a drinks company (Seagram) owned Universal Music, before selling it to a water utilities company (Vivendi), and, long before that, EMI was owned by a light bulb company (Thorn Electrical Industries). We have got used to this current period of corporate stability for the major record labels, but this situation is a reflection of the recorded music business being in such a poor state that there was little M&A interest. Nonetheless it is all changing, potentially heralding a return to the past. Everything has happened before and will happen again.

Spotify Q1 2018 Results: Full Stream Ahead

Spotify released its first ever quarterly earnings results today. The results reflect strong performance in its first public quarter with growth in subscribers, total users, revenue and also gross profit. Here are the highlights:

  • Subscribers: Spotify hit 75 million subscribers, up 44% from 71 million in Q4 2017, which is wholly in line with MIDiA’s 74.7 million forecast and reflects solid growth for a non-paid trial quarter. That is an increase of 22.9 million on Q1 2017, at which stage total subscribers stood at 52 million. The fact the year-on-year growth is 44% of the total subscriber count from one year previously reflects just how far Spotify has come in such a short period of time. Q2 2018 will be a paid trial quarter so subscriber growth will be markedly stronger. Expect Q2 2018 subscribers to reach around the 82 million mark.
    Takeaway: Spotify’s subscriber growth is maintaining its solid organic growth trajectory, with paid trials continuing to be the growth accelerant that keep total growth on a steeper growth curve.
  • Revenues: Revenues were up 26% from €902 million in Q1 17 to reach €1,139 million, though this was 1% down on Q4 2017. Premium revenue was €1,037 million, comprising 91% of all revenues. Ad Supported revenues were €102m growing at a faster rate (38%) than premium but contributing fewer net new dollars. Labels and publishers have empowered Spotify to fully commercialize its free user base and the dividends are now beginning to manifest, all be it from a low base.
    Takeaway: Premium revenues continue to be the beating heart of Spotify’s business. Though ad supported represents a massive long term opportunity, that business is going to take much longer to kick into motion. Growth though is not linear and is shaped by seasonal trial cycles.
  • Churn: Quarterly churn fell below 5% in Q1 2018 (it was 5.1% in Q4 2017), following a long term downward trend that was only interrupted by a 0.4% point increase in Q3 2017. Applying the churn rate to Spotify’s subscriber base reveals that it while its net subscriber additions for Q1 2018 were 4 million, the gross additions (ie including churned out users) was 7.4 million.
    Takeaway: Any growth stage business that is aggressively pursuing audience growth faces the challenge of bringing a high share of low value users into the acquisition funnel, which in turn keeps churn up. Sooner rather than later Spotify is going to need to start focusing more heavily on retention than acquisition, especially in more mature markets.
  • Costs and margins: Gross margin was 24.9% in Q1, up from 24.5% in Q4 and 11.7% in Q1 2017. This was above guidance and Spotify attributes this largely to changes in estimates for rights holder costs. Spotify is doing everything it can to highlight just how good a job it is doing of reducing rights costs. ‘Recalculating’ costs for Q1 2018 has the convenient benefit of extending that pre-DPO narrative into its first earnings.
    Takeaway: Spotify’s Barry McCarthy stated prior to Spotify’s listing was going to remain squarely focused on ‘growth and market share’. So modest progress on margins needs to be set in the context of a company that is focused on growing now while the market is still in flux, and planning to tighten its belt when the market starts to solidify. Spend now while growth is to be had.

The Netflix Comparison

Since its listing, Spotify has found itself rocketed into the spotlight with no end of financial analysts now setting their sights on the streaming company and making their own estimates for revenues and subscribers. The somewhat predictable dominant narrative is how much Spotify does, or does not, compare to Netflix. Spotify is going to have to get used to those sorts of comparisons. The good news for Spotify is that its first earnings compare well with when Netflix was at similar stage of its growth.

In Q4 2015 Netflix hit 74.8 million total subscribers, up 5.6 million from the previous quarter. Streaming revenues were up 6% to $1.7 billion while cost of revenues were at 70% of revenues and quarterly premium ARPU was $22.37. Over the course of the next 12 months Netflix would add 19 million subscribers to reach 93.8 million by end 2016.

By comparison, in Q1 2018 Spotify hit 75 million total subscribers, up 4 million from the previous quarter. Revenue was up down 1% on previous quarter while cost of revenues were at 75% of revenues and quarterly premium ARPU was €13.80.

It is clear these are snapshots of companies at very similar stages of growth, however Spotify has slightly higher cost of revenue and lower ARPU than Netflix did in Q4 2015, both of which need fixing. The indications are thus that Spotify has a solid chance of following a similar path. Indeed, MIDiA’s estimate for Spotify’s end of year subscriber count is 93 million, putting it on exactly the same growth trajectory as Netflix was in 2016. For now, looking at Netflix’s performance with a 27 months look back is a pretty good proxy for where Spotify is going to be getting to.

Conclusion

Right now, Spotify is trying to strike a Goldilocks positioning: not too disruptive to the traditional music business but not too supportive of it either. Spotify needs to talk out of both sides of its mouth for a while, showing how much value it is delivering to traditional rights holders but also how it is an innovative force for change. The F1 filing leaned more towards the latter position, while the Q1 earnings took a more matter of fact approach. But over time, expect Goldilocks to start trying more of daddy bear’s porridge.

These findings are just a few highlights from MIDiA’s 6 chart Spotify Q1 2018 Earnings report which will be published Thursday 3rdMay. The report includes, alongside core earnings data, proprietary MIDiA metrics such as gross profit per subscriber and gross subscriber adds. If you are not already a MIDiA client and would like to learn how to get access to this report and other Spotify research and metrics, email stephen@midiaresearch.com

Spotify D(PO)-Day

downloadArguably the most anticipated day in the history of digital music is upon us. By the end of it we will have the first hint at whether Spotify is going to fall at the Snap Inc. or Facebook end of the spectrum of promising tech IPO, or DPO in the case of Spotify. Of course, we’ll need a few quarters’ worth of earnings in place before firmer conclusions can be drawn as to the strength of Spotify as a publicly traded company, but the first 24 hours will lay down some markers. However, it is the mid and long-term market factors that will give us the best sense of where Spotify can get to. Here are a few pieces of pertinent market context that can help us understand where Spotify is heading:

  • Streaming is just getting going: Downloads are yesterday’s legacy market, streaming is the future. But streaming has a long way yet to go. To date, downloads have generated around $35 billion in revenue for labels since the market started. That compares to around $15 billion for subscriptions. Apple accounted for around $23 billion of that download revenue, Spotify accounted for around $5 billion of that subscription revenue.
  • Spotify retains leadership: While the streaming market is competitive, Spotify has retained around 36% subscriber market share. However fast the market has grown, Spotify has either matched or beaten it. Apple is growing fast too but is adding fewer net new subscribers per quarter than Spotify is. Fast forward 12 months from now, Spotify will still be the number one player. Fast forward 24 months, it will probably still be.
  • Tech majors want the same thing: Of all the big streaming services, only Spotify is truly independent. Apple Music – Apple, Amazon Prime Music – Amazon, YouTube – Google, QQ Music – Tencent, Deezer – Access Industries, MelON – Kakao Corp, and now, Facebook) all have parent companies that have ulterior business objectives with music streaming. None of them have to seriously worry about streaming generating an operating profit. This means that there is little pressure in the marketplace to drive down label rights costs. All of this means that Spotify is the only main streaming service that is trying to make the model commercially sustainable.
  • Spotify can’t be Netflix yet: As much as the whole world appears to be saying Spotify needs to do a Netflix (and it probably does) it just can’t, not yet at least. In TV, rights are so fragmented that Netflix can have Disney and Fox pull their content and it still be a fast growing business. If UMG pulled its content from Spotify, the latter would be dead in the water. So, Spotify will take a subtler path to ‘doing a Netflix’, first by ‘doing a Soundcloud’ i.e. becoming a direct platform for artists and then switching on monetisation etc. In the near-term Spotify will happily have record labels sign artists that bubble up on the platform. But over time, expect Spotify to start competing for some signings.
  • Unpicking the distribution lock: The major record labels represent around 80% of recorded music revenues globally on a distribution basis, but just 61% on a copyright ownership basis. They get the extra market share through the distribution they provide indies, either directly or via divisions like Sony’s The Orchard or WMG’s ADA. The 80% share gives the majors the equivalent of a UN Security Council veto. Nothing gets through without their approval, which acts as a brake on Spotify’s ambitions. But, if Spotify was to persuade large numbers of those indies distributing through majors to deal direct, then some of that major power will be unpicked, which, combined with increased revenue, subscribers and market share, would strengthen Spotify’s hand.

Right now, Spotify has soft power (playlist curation, user-level data, subscriber relationships etc.). Spotify’s long-term future will depend on it building out its hard power and bringing it to bear in a way that brings positives both for it and for its industry partners. That will be a tightrope act of the highest order.

If you want the inside track on Spotify’s metrics, get access to MIDiA’s latest report:

Spotify by the Numbers: Trials, Churn and Margin which is available to purchase on MIDiA’s report store and to MIDiA clients via our subscription service.