Spotify May Already Be Too Big for the Labels to Stop it Competing With Them

Spotify’s Daniel Ek is betting big on developing a ‘two sided marketplace’ for music. With the company’s market cap on a downward trend despite strong growth metrics, Ek might find himself having to play up the disruption narrative more boldly and more quickly than he’d planned. Investors are betting on a Netflix-like disruptor for the music industry, rather than a junior distribution partner for the labels. And this is where it gets messy. Whereas Netflix can play individual TV networks off each other and can even afford to lose Disneyand Fox, each major record label has enough market share to have the equivalent of a UN Security Council Veto. So when Spotify announced it was going to let artists upload music directly and thenadded distribution to other streaming services via DistroKid,the labels understandably smelt a rat. To the extent they threatened to block access to India. Spotify’s balancing act may be reaching a tipping point (mixed metaphor pun intended), but it may already be too late for the labels to act. Here’s why…

In search of market share

If Spotify is able to become more competitive (and therefore threatening) to labels and keep hold of them, it will all be down to market share. The less market share the big labels have on Spotify, the more negotiating power Spotify has. It is a classic case of divide and rule. If Spotify really wants to play the role of market disruptor (and so far we have strong hints rather than outright statements), it will need to whittle down the power of the majors before they call it and pull their content. Here’s a scenario for how Spotify could achieve that.

1 – Direct indie label deals

The first step is detangling embedded indie label market share from the majors that distribute them and therefore wield their market share as part of their own in licensing negotiations. There are two ways to measure market share:

1. By distribution (this includes indie labels distributed via major labels being included in the share of the bigger labels)
2. By ownership (this measures based on the original label, so does not count any indie labels as part of major labels)

By the first measure, the major labels had an 82% market share in 2016 and 79% market share in 2017. By the second measure, according to the WINTel report, major label market share was 62% in 2016 (the 2017 WINTel number is not yet out but will be shortly). So, if Spotify does direct deals with the larger indies currently distributed by majors or major-owned distributors (or persuades them to join Merlin), it unpacks up to more than a fifth of major label market share.

2 – More artists direct

DIY artists uploading directly to Spotify is a long-term play, aimed at harnessing the potential of tomorrow’s stars. In the near term, these artists will generate a smallish amount of streams, even with a helping hand from Spotify’s algorithms and curators. There are about 300 artists right now; let’s say Spotify gets to 2,500 next year, it could potentially deliver around a third of a percent of share of Spotify streams.

3 – Library music

Fake artist gatesaw a lot of people getting very hot under the collar, but nothing that was done was against any rules. Instead library music companies like Epidemic Sounds were – and still are – serving tracks into mood based playlists. The inference is that Spotify is paying less for Epidemic Sounds tracks than to labels. Whether it is or isn’t, this still eats away at label market share on Spotify. With a bit more support from Spotify’s playlist engine, these could account for around 0.7% of streams.  Coupled with artists direct, that’s a single point of share. Not exactly industry changing, but a pointer to the future, and a point of share is a point of share.

4 – Top 20 artists

Where Spotify could really move the needle is doing direct deals with top tier, frontline artists, probably on label services deals, as Spotify doesn’t appear to want to become a copyright owner – not yet at least. Netflix is funding its original content investments with around $1.5 billion of debt every two years, which it raises against its subscriber growth forecasts. No reason why Spotify couldn’t do the same, paying advances that other labels couldn’t compete with. The top 20 artists on Spotify account for around 22% of all Spotify streams. If Spotify could do direct deals with each of them and promote the hell of out of their latest releases, they could contribute up to 15% of all streams. Of that top 20, Taylor Swift is on the lookout for a new label, and Drake is putting out ‘albums’ so frequently that he must be pushing up close to the end of his deal.

When we add all these components together we end up in a situation where the major labels’ share of total streams would be just 47%. Spotify would have the second highest individual market share, while regional repertoire variations mean that SME and WMG could drop towards 10-11% in a couple of regions.

Of course, this is a hypothetical scenario, and one on steroids: the odds of Spotify signing up all the top 20 artists in the next 12 months is slim, to put it lightly, but it is useful for illustrating the opportunity.

Prisoners’ Dilemma

At this stage we move on to a prisoners’dilemma scenario for the majors:

• All of the majors help Spotify’s case by over prioritising Spotify as a promotional tool in light of its share of total listening compared to radio, YouTube, other streaming services etc
• WMG and SME probably couldn’t afford to remove their content from Spotify but would be watching UMG, the only one that probably feel confident enough to do so
• However, UMG would be thinking if it jumps first and removes its content, each of the other two majors would benefit from it not being there (and would probably be secretly hoping for that outcome)
• Each other major would be thinking the same, and regulatory restrictions prevent the majors from discussing strategy to formulate a combined response
• But even if UMG did pull its content, this would hurt Spotify but would not kill it (Amazon Prime Music launched without UMG and spent 15 months growing just fine until UMG came on board)
• Spotify could easily tweak its curation algorithms to minimise the perceived impact of the missing catalogue, making it ‘feel’ more like 10%
• So, the likely scenario would be each major paralysed by FOMO and so none of them act

Thus, maybe Spotify is already nearly big enough to do this, and could do so next year. And the more that Spotify’s stock price struggles, the more that Spotify needs to talk up its disruption. History shows that when Spotify makes disruptive announcements, its stock price does better than when it delivers quarterly results. Maybe, just maybe, the labels have already missed their chance to prevent Spotify from becoming their fiercest competitor. The TV networks left it too late with Netflix…history may be about to repeat itself.

Spotify, DistroKid and the Two Sided Marketplace

Spotify has taken a minority stake in DistroKid. In itself, it may be a slightly left field but relatively insignificant move, except that it is in fact one small but important step on a much bigger journey. Back in September, Spotify announced that it was enabling artists to upload their music directly to Spotify, simultaneously aggravating record labels, distributors, DIY platforms and Soundcloud all in one fell swoop. This raised an intriguing possibility of a ‘coalition of the willing’ forming against Spotify from slighted partners and competitors. But that’s another blog post. Right now, though, DistroKid’s role in this performance is as an enabler for Spotify in its path to becoming a next generation label / creating a two-sided marketplace (delete as appropriate depending on how all this affects your business).

Bringing efficiencies into the supply chain

Spotify’s DistroKid deal will enable Spotify’s direct artists to “seamlessly distribute their music to other platforms through DistroKid”.So, instead of putting all their streaming eggs in one basket, Spotify’s direct artists now get to stream their music on Apple, Amazon, Deezer and the rest too. What wasn’t made clear in the announcement is whether Spotify will have visibility of the streaming data from those other platforms and / or whether the revenue will be recognised as Spotify revenue and then distributed to its artists. If these statements were to be the case, then Spotify’s competitors would be feeding it data and revenue…

UPDATE: A Spotify spokesperson clarified that “Spotify has no rights to see data from other digital service providers and DistroKid will not share confidential information.”

Why this relatively small announcement matters, is that it is another piece of Spotify’s strategy of shifting its way up the value chain by a) removing some of the distribution component and b) entering into direct relationships with artists. It’s what west coast tech firms call ‘bring efficiencies into the supply chain’. If it all works, Spotify will get more margin, artists will get more margin, but middle players (labels, distributors etc.) will get squeezed.

Treading a subtler path

This is how Spotify can edge quietly towards becoming a record label without going nuclear from the get go. It is a strategy we predicted by in April ahead of Spotify’s DPO:

“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’d 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.”.

The challenge for Spotify is whether it can execute on the strategy quickly enough to excite investors (and thus drive up the share price), but slowly enough to keep record labels on board…so that when they realise where things are heading then it is too late for them to do anything about it.

 

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.

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.

This Is What Post-IPO Life Will Look Like For Spotify

With a fair wind, Spotify’s long-anticipated public offering should happen before the end of Q2 2018 (and yes, probably a direct listing rather than an IPO but ‘IPO’ worked better in the title!) . The music industry will be watching with keen interest as it is going to be the bellwether for the streaming music sector. Posting three or four successive quarters of well-received earnings will be key to Spotify’s life as a public company. Note my careful use of words, ‘well-received earnings’, not ‘strong earnings’. Spotify’s currently challenged underlying financials are not going to change in any fundamental sense over the course of nine to 12 months, so it will need to construct a series of narratives and targets that Wall Street will buy into. The only problem is, Wall Street often has very high expectations for growth stage tech stocks, and falling short of those expectations can result in a tumbling stock price, even if the growth trend is actually solid.

When narratives alone will not be enough

I’ve written before about how Spotify will need to construct a number of new narratives for life as a public company. They will need to demonstrate:

• Sustained strong growth in subscribers, users and revenue
• Improved profitability metrics
• Diversification of revenue streams
• Reduction of risk factors

All except the first could prove contentious, as many of the solutions will be inherently challenging for record label partners. Netflix has set a strong precedent for how to drive net margin with a 70% rights cost case (like Spotify’s) by creating its own content and using accounting technique,  such as amortization of costs, to turn cost into profit on the books. Netflix can get away with this because there are many TV networks so no single one can kill the service by removing its content. For example, Disney recently announced it was pulling its content, but Netflix continues to go from strength-to-strength. Spotify without Universal Music would swiftly wither on the vine. Spotify ‘becoming a label’ will be highly disruptive so it will have to do it slowly and in non-obvious ways. The news today that Spotify has acquired online music and audio recording studio Soundtrap – reportedly for $30 million – fits this thinking. In effect, subtly reversing into becoming a label. Meanwhile, it will need to have other new less disruptive revenue streams to spin narratives around, such as selling data to music industry stakeholders.

The upshot of all this is that during its first year as a public company, those narratives are unlikely to be enough. Instead, investors will be applying forensic scrutiny to Spotify’s user and revenue metrics. More than that, investors will set their own targets and if Spotify misses the consensus of these third-party targets, the share price will go down. Apple tried to distract investors from its slowing core metrics in 2016 by releasing a supplemental information document that focused on new metrics such as revenue per user. But investors refused to have their fixed gaze moved away from iPhone shipments.

So, Spotify will live or die by meeting investor-set subscriber growth targets? This means it will have to tread a delicate line between being bullish about its prospects to get investors’ interest piqued, but not so bullish as to raise their expectations too much. What complicates matters further though is the relationship between user growth and stock price. Pandora and Netflix have had very different journeys in the last 24 months, but both have endured ‘4 Quarter Kill Zones’ during which period stock prices struggled:

• Pandora: Pandora’s post-earnings closing stock price declined at ever-greater rates than its monthly active user (MAU) count did. In Q1 2017 Pandora’s stock price fell by $0.11 for every million MAUs lost. By Q3 2017 this rate was $0.79.
• Netflix: Between Q4 2015 and Q4 2016, Netflix added 12 million memberships (subscribers and trialists), yet its share price fell from $107.89 to $99.80. Investors, quite simply, expected even stronger growth. The irony is that since that time Netflix has continued to add memberships at a similar rate but its stock price has rocketed to $202.68 in Q3 2017.

Growth at what cost?

The lesson from these two cautionary tales is that it is not so much user metrics that is essential, but meeting user metric expectations. And Spotify will need to be careful about how it meets those targets. Growth stimuli like $1 for three-month super-trials can spike growth but hit profitability, which will be there for all to see in SEC filings. Therefore growth cannot come at any cost. In a similar vein, with market maturity approaching in many major western markets, Spotify will need to rely on a combination emerging markets for subscriber growth, and total free users (everywhere) to drive its user numbers, both of which will dent ARPU and margin. It is yet another balancing act for Spotify to manage and navigate.

Music market IQ

Spotify has one major advantage and one major disadvantage going into its flotation:

1. Disadvantage: Since large investors have steered clear of the recorded music business for so long, the level of institutional market IQ is relatively low. The music business is notorious for being highly nuanced. This means that although big investment companies have been busy getting up to speed over the last 18 months, their expertise in music still lags massively behind the other sectors they invest in. Pandora learned the hard way that investors did not have the market IQ to differentiate between its ad supported radio model and Spotify’s subscription Similar things will happen to Spotify.
2. Advantage: There are very few places truly big investors can put their money. Spotify’s IPO and a potential UMG sale or listing are about it. Big institutions see WMG as too small, and Sony Music as too small a part of Sony Corp. It’s no coincidence perhaps that UMG is reported to have been valued at between $30-$40 billion by Vivendi, conveniently keeping it well north of Spotify’s likely flotation valuation of $15-$20 billion.

So, with institutional investor demand massively exceeding supply, Spotify – and potentially UMG – could be very well placed to benefit. But a strong start can soon falter, as in the case of Snap Inc., which has fallen from an opening $24.48 to $12.56 now. The beauty of being a privately held company is that you can chose what metrics to report, and when. If you’ve had a tough quarter you can keep quiet until you have a good one. When you’re public you have no such luxury. It is warts and all, every quarter. Spotify’s life as a public company will be as much about managing expectations as it will be about driving growth.