Profit Didn’t Disappear, It Just Moved

One of the recurring themes in analysis of tech businesses is the role of profit, and most often, the apparent lack of it – or at the very least, the way in which it plays second fiddle to growth. Amazon, one of the most successful global businesses in today’s global economy, famously sacrificed profit for much of its existence in order to focus on long-term growth and expansion. Similarly, Spotify remains laser-focused on growth and market share, almost apologizing when it generated a net profit for the first time in Q4 2018. The logical way to interpret this worldview is that it points to a lack of sustainability in the underlying business models of such tech companies, and that profit is a scarce commodity in the world of tech business. In actual fact, profit is still being made right across the value chain. It is simply not appearing on the balance sheets of tech companies.

Profit, an ‘old world metric’

Back the early 2000s, at Jupiter Communications in my early days as an internet analyst (back when you could actually have that job title), I used to tire of hearing the same line from dotcom start-ups when asked about profitability: “Profit is an old world metric. We measure ourselves by internet-era metrics.” When the dotcom bubble burst and VCs started pulling their money out of the dotcom space, virtually all of those business quickly learned that profit really did matter when the investment dried up. Most of those companies folded very quickly (Amazon being one of a few strong exceptions to the rule). Fast forward nearly two decades and that ‘new world’ mentality is more in evidence than ever before. So, what gives?

The development of finance is one of the most important 21^st century events

One of the most important developments in capitalism in the 21^st century has been the development of the financial sector, both in terms of the sophistication of products and services and in terms of the sheer scale of value that flows through it. For tech businesses, this has manifested as unprecedented access to finance at all stages of business. Historically, traditional businesses had some access to start-up capital, though it was often debt-based such as taking a bank loan. Fewer new businesses came to market, but those that did had a stronger profit imperative as they needed to service their start-up debt. Tech start-ups now most often have ready access to equity-based finance (i.e. selling a share of their business in return for investment) long before they go to market, and then have the further ability to raise more investment as they build their businesses. This enables companies to focus on growth, product development and brand building at a much faster rate than if they were relying upon organic revenue growth for funding. We wouldn’t have most of the big successful tech companies we do today without this model. The question still remains, however: when and where does profit fit in?

When looking at the financial reports of many tech businesses, net profit is conspicuous by its absence. For example, Uber has warned that it ‘may never be profitable’. This does not mean that profit is not being made, however – it is just found in different places. Take the example of Spotify. It is generating enough gross margin to be able to invest heavily in its business and to pay salaries that are competitive enough to ensure it can build an A-class team. It also generated enough money at its DPO to ensure its founders, investors and record labels all profited from the sale. Meanwhile, Spotify and other streaming services are driving revenue and profit for rightsholders, delivering nearly $10 billion of record label revenue in 2018 alone. Profit is being made by Spotify; it has simply moved across the value chain.

A new commercial ecosystem

The Spotify example illustrates how profit has shifted across the value chain in tech businesses, delivering profit for investors, suppliers and founders. In effect a new ecosystem has evolved in which the new profit centres can support the distribution part of value chain indefinitely. With growth valued over profitability by shareholders, the markets provide further sustenance to the ecosystem.

This model works, until it doesn’t. The big risk factor here is availability of credit. My colleague Tim Mulligan argues that the current availability of credit is the result of an abnormal macro credit cycle rather than a new model of economic sustainability, with interest rates at historical lows. As soon as interest rates go up, VC funding will significantly decrease due to institutional money leaving the VC funds for the equity markets. The corporate debt market will then start to dramatically contract, reducing the working capital available to unprofitable public businesses. On top of this, the cost of holding leveraged positions funded through the short-term money markets will start to become too expensive for many of the existing hedge funds to maintain their positions. An interest-rate driven, financial domino effect could happen very quickly.

Every time we have a bubble we are told that this time it’s different, and it never actually is. The financial component of the value chain can only generate profit as long as its primary cost base – i.e. interest rates – remain low. When they stop making profit, the whole ecosystem crumbles. At which point, tech companies will be well placed to consider the old maxim: revenue is vanity, profit is sanity.

The Three Eras Of Paid Streaming

Streaming has driven such a revenue renaissance within the major record labels that the financial markets are now falling over themselves to work out where they can invest in the market, and indeed whether they should. For large financial institutions, there are not many companies that are big enough to be worth investing in. Vivendi is pretty much it. Some have positions in Sony, but as the music division is a smaller part of Sony’s overall business than it is for Vivendi, a position in Sony is only an indirect position in the music business.

The other bet of course is Spotify. With demand exceeding supply these look like good times to be on the sell side of music stocks, though it is worth noting that some hedge funds are also exploring betting against both Vivendi and Spotify. Nonetheless, the likely outcome is that there will be a flurry of activity around big music company stocks, with streaming as the fuel in the engine. With this in mind it is worth contextualizing where streaming is right now and where it fits within the longer term evolution of the market.

The evolution of paid streaming can be segmented into three key phases:

1. Market Entry: This is when streaming was getting going and desktop is still a big part of the streaming experience. Only a small minority of users paid and those that did were tech savvy, music aficionados. As such they skewed young-ish male and very much towards music super fans. These were people who liked to dive deep into music discovery, investing time and effort to search out cool new music, and whose tastes typically skewed towards indie artists. It meant that both indie artists and back catalogue over indexed in the early days of streaming. Because so many of these early adopters had previously been high spending music buyers, streaming revenue growth being smaller than the decline of legacy formats emerged as the dominant trend. $40 a month consumers were becoming $9.99 a month consumers.
2. Surge: This is the ongoing and present phase. This is the inflection point on the s-curve, where more numerous early followers adopt. The rapid revenue and subscriber growth will continue for the remainder of 2017 and much of 2018. The demographics are shifting, with gender distribution roughly even, but there is a very strong focus on 25-35 year olds who value paid streaming for the ability to listen to music on their phone whenever and wherever they are. Curation and playlists have become more important in order to help serve the needs of these more mainstream users—still strong music fans— but not quite the train spotter obsessives that drive phase one. A growing number of these users are increasing their monthly spend up to $9.99, helping ensure streaming drives market level growth.
3. Maturation: As with all technology trends, the phases overlap. We are already part way into phase three: the maturing of the market. With saturation among the 25-35 year-old music super fans on the horizon in many western markets, the next wave of adoption will be driven by widening out the base either side of the 25-35 year-old heartland. This means converting the fast growing adoption among Gen Z with new products such as unbundled playlists. At the other end of the age equation, it means converting older consumers— audiences for whom listening to music on the go on smartphones is only part (or even none) of their music listening behaviour. Car technologies such as interactive dashboards and home technologies such as Amazon’s echo will be key to unlocking these consumers. Lean back experiences will become even more important than they are now with voice and AI (personalizing with context of time, place and personal habits) becoming key.

It has been a great 18 months for streaming and strong growth lies ahead in the near term that will require little more effort than ‘more of the same’. But beyond that, for western markets, new, more nuanced approaches will be required. In some markets such as Sweden, where more than 90% of the paid opportunity has already been tapped, we need this phase three approach right now. Alongside all this, many emerging markets are only just edging towards phase 2. What is crucial for rights holders and streaming services alike is not to slacken on the necessary western market innovation if growth from emerging markets starts delivering major scale. Simplicity of product offering got us to where we are but a more sophisticated approach is needed for the next era of paid streaming.

NOTE: I’m going on summer vacation so this will be the last post from me for a couple of weeks.