What Spotify Can Learn From The Roman Slave Trade

OK, you’re going to have to bear with me on this one, but let me take you back to 2^nd century Rome….

Roman Slaves

The Roman Empire was at the peak of its powers. Its borders stretched from Scotland down to Syria and across to Armenia, and across its dominions Rome spread its culture, language, administration and of course, military prowess. It brought innovations such as under floor heating, running water, astronomy and brain surgery but the consensus among many modern day historians is that the Roman Empire could have been much more. Rome was fundamentally a military, expansionist state. Its endless conquests produced a steady flow of captured people that fuelled Rome’s most important economic interest: the slave trade. By the mid 2^nd century around 1 in 4 Romans were slaves. It was common for wealthy citizens to have 40 or more household slaves while the super-rich had hundreds.

The Importance Of Economic Surplus

The problem was that the over-supply of labour meant that wages were horrifically low for the masses while the rich over spent on slaves to keep up with the neighbours. The net result is that the Roman Empire was not able to create an economic surplus across its population, which meant that there was insufficient investment in learning, science and culture. If that surplus had been created, Rome would have spawned a generation of innovators, inventors and entrepreneurs that should have created an industrial revolution. This raises the tantalizing possibility of steam power and steel emerging before the middle ages, which in turn could have meant that today’s technology revolution might have happened hundreds of years ago by now.

Instead, the Roman Empire eventually crumbled with Europe forgetting most of Rome’s innovations, paved roads weeding over, aqueducts running dry and heated floors crumbling. We had to wait until the second half of the 18^th century for the Industrial Revolution for the change, which crucially followed and overlapped with the Age of Enlightenment, a period of learning unprecedented since the Renaissance (when everyone busied themselves relearning Rome’s lost secrets) which was fuelled by Europe’s economies have developed sufficiently to create enough surplus for more than just the aristocracy to learn, invent and create. 

So, Rome inadvertently held back human progress by half a millennium because of its obsession with slaves. But what does that mean for Spotify? The key lesson from the Roman experience is that being saddled with too large a cost base may not prevent you from becoming big but it will hold you back from fulfilling your potential and from building something truly lasting. You can probably tell now where I am heading with this. Spotify’s 70% rights cost base is Rome’s 1 in 4 are slaves.

Product Innovation Where Are You?

Spotify has made immense progress but it and the overall market have done too little to innovate product and user experience.  There’s been business and commercial innovation for sure but looking back at the streaming market as a whole over the last 5 years, other than making playlists better through smart use of data and curation teams, where is the dial-moving innovation? Where are the new products and features that can change the entire focus of the market. Compare and contrast how much the likes of Google, Facebook and Amazon have changed their businesses and product offerings over that period. Streaming just got better playlists. Musical.ly shouldn’t have been a standalone company, it should have been a feature coming out of Spotify’s Stockholm engineering team. But instead of being able to think about streaming simply as an engine, Spotify has had to marshal its modest operating margins around ‘sustaining’ product development and marketing / customer acquisition.

Post-Listing Scrutiny

Spotify will likely go public sometime next year as a consequence. But once public it will need to be delivering demonstrable progress towards profit with each and every quarterly SEC filing. Growth alone won’t cut it. Just ask Snap Inc. Spotify does not have a silver bullet but it does have a number of different switches it can flick that will each contribute percentages to net margin and that collectively can help Spotify become commercially viable and in turn enable it to invest in the product and experience innovation that the streaming sector so crucially lacks.  Spotify hasn’t done these yet because most will antagonize rights partners but it will be left with little option.

Spotify The Music Company

To say that Spotify will become a label is too narrow a definition of what Spotify would become. Instead it would be a next generation music company, encompassing master rights, publishing, A+R, discovery, promotion, fan engagement and data, lots of data. If Spotify can get a couple of good quarters under its belt post-listing, and maintain a high stock price then it could go on an acquisition spree, acquiring assets for a combination of cash and stock. And the bigger and bolder the acquisition the more the stock price will rise, giving Spotify yet more ability to acquire. This is the model Yahoo used in the 2000s, with apparently over-priced acquisitions being so big as to impress Wall Street enough to ensure that the increase in market cap (ie the value of its shares) was greater than the purchase price. Spotify could use this tactic to acquire, for example, Kobalt, Believe Digital and Soundcloud to create an end-to-end, data-driven discovery, consumption and rights exploitation music power house.

What other ‘label’ could offer artists the end-to-end ability to be discovered, have your audience brought to you, promoted on the best playlists, given control of your rights and be provided with the most comprehensive data toolkit available in music? And of course, by acquiring a portion of the rights of its creators though not all (that’s where Kobalt / AWAL comes in) Spotify will be able to amortize some of its content costs like Netflix does, thus adding crucial percentages to its net margin. It will also be able to do Netflix’s other trick, namely using its algorithms to over index its own content, again adding crucial percentages to its margin.

Streaming Is The Engine Not The Vehicle

The way to think about Spotify right now, and indeed streaming as a whole, is that we have built a great engine. But that’s it. We do not have the car. Streaming is not a product, it is a technology for getting music onto our devices and it is a proto-business model. While rights holders can point to areas where Spotify is arguably over spending, fixing those will not be enough on their own, they need to accompany bolder change. Once that change comes Spotify can start to fulfil its potential, to become the butterfly that is currently locked in its cocoon. While rights holders we be understandably anxious and may even cry foul, they have to shoulder much of the blame. Spotify simply doesn’t have anywhere else to go. Unless of course it wants to end up like Rome did….overrun by barbarians, or whatever the music industry equivalent is…

Just How Well Is Streaming Really Doing?

All of the three major record labels announced strong streaming music revenue growth in the 2^nd quarter of 2016. On the surface it is a clear cut success story, but as is so often the case with music industry statistics, all is not quite how it seems.

The Global Streaming Market

First of all, let’s look at the global picture. According to the IFPI’s Recording Industry in Numbers (RIN) 2016 edition record label streaming revenue grew by 45% in 2015 reaching $2.9 billion, up from $1.9 billion in 2014. But even that number requires a little due diligence. The IFPI restates its historical numbers every year to reflect the current year’s exchange rates, which can, and does, overstate things. Indeed, a quick look at the 2015 edition of RIN shows that streaming revenue was reported as $2.2 billion for 2014. So on a non-adjusted basis (i.e. without restating the numbers) streaming revenue actually grew by 31%.

Spotify’s Contribution

31% is still impressive growth but the plot thickens when we factor in Spotify’s contribution to those label revenues. Spotify’s total royalty payments were $1.9 billion in 2015, of which around $1.4bn were label payments, and of those around $1.1 billion were royalty payments (i.e. minus advance payments such as Minimum Revenue Guarantees (MRGs) paid in anticipation of future growth). That $1.1 billion was up 85% from $610 million in 2014. As the IFPI numbers only represent payments in respect of actual royalties (i.e. minus advance payments) the Spotify label royalty payments can be considered as a share of that global total. That share was 39% of all label streaming revenue in 2015, up from 28% in 2014.

This results in 2 interesting points:

1. Spotify’s share of the global music subscriber total was 35% in 2014 and 37% in 2015. So the label royalty payments over indexed in 2014 and under indexed in 2015. The fact that 2015 was a big year for heavily discounted promotional offers such as $1 for 3 months most probably plays a key role here.
2. If we remove the Spotify label royalty payments from the equation, label payments from other streaming services grew by just 10% from $1.6 billion in 2014 to $1.8 billion in 2015. Not exactly the most robust of pictures for the wider streaming market place.

So much for 2015, let’s look at where we are now. All three major labels reported strong streaming growth in Q2 2016. Together they reported $918 million, up 51% from $607 in Q2 2015. That growth generated $311 million of new digital revenue. At the same time, and as a direct consequence, download revenue fell by 24% from $925 in Q2 2015 to $705 million. So streaming is now nearly as big as downloads were 12 months ago. The net increase in combined digital music revenue was $91 million, or a combined digital growth rate of 6%. Solid growth, but not far from treading water. This is a transition process, not a transformative growth process.

Universal Is The Big Streaming Winner

Each of the 3 majors had differing streaming experiences. Universal was the big winner, growing its share of major label streaming revenue from 38% in Q2 2015 to 42% in Q2 2016 (boosted more than other majors by ‘embedded’ independent label revenue). UMG’s streaming revenue grew by more than 60% while Sony and Warner grew by an average of 42%. However, it is important to note that UMG’s reported streaming numbers may be skewed more by currency restating than the other majors, so this share increase might be slightly on the high side.

Sony Music meanwhile lost share from 35% to 33% while Warner Music, which was most coy about its streaming revenue in its reporting, also saw a fall from 26% to 25%. Warner’s and Sony’s loss was Universal’s gain. An interesting side note: Sony was the only major that saw growth in physical music sales over the period. Yet more evidence of the Adele effect?

The Role Of Advanced Payments

But perhaps the most important element of the majors’ streaming reports is the difference between royalty payments (i.e. money earned for music streamed) and total streaming revenue (i.e. including advanced payments such as MRGs). Spotify states rights payments are 70% of its revenue though its 2015 accounts show royalty payments as 82% of revenue due in large part to advanced payments. Using this benchmark advanced payments represent around 16% of all label payments. Applying this to the label reported numbers we can extrapolate that $145 million of all major label streaming revenue is advanced payments.

Why does this matter? Because this is the major record label’s streaming reality distortion field. They get streaming revenue regardless of how well the marketplace actually performs. If a streaming service pays an MRG of $30 million but only earns $10 million the label still gets $30 million. So in that scenario the label’s view of that part of the streaming music market is 3 times better than it actually is. If the music service wins, the label wins, if the music service loses, the label still wins. This disconnect between how the market performs and how the label performs is one of the festering wounds of the streaming music market. And its revenue impact is massive. In fact, advanced label streaming payments were 158% of the $91 million that digital music revenue grew by in Q2 2016. Yes, that’s right, advanced streaming payments accounted for all of the digital music growth, and more.

Streaming Will Continue To Grow, But Haunted By Advanced Payments

So where does all this leave us? The streaming market is without doubt entering a phase of accelerating growth and is doing enough to counter the resulting decline in downloads to contribute to a combined total recorded music revenue growth of 4% for major labels in Q2 2016. But growth is not quite as stellar as the headline numbers would suggest, with the single most important factor being the impact of advanced payments distorting the bigger picture and crippling cash flow for streaming music services. Expect more impressive growth throughout the remainder of 2016 but also expect streaming music economics to continue to be fractured.

Why Profit Doesn’t Come Into It For Apple Music

Apple has only ever been in the music business in order to sell more devices.  Apple does not need to make money from music nor has it ever needed to.  That doesn’t stop it being a crucially important music industry partner (in fact Apple is still pretty much the single most important partner on a global basis).  Nor does that mean that Apple doesn’t care about music or that it doesn’t take its role in the marketplace seriously.  But Apple is not in this game to make money.  Apple routinely ran the iTunes Store at ‘an about break-even basis’ which is financial report code for ‘at a slight loss’.  (Or in fact probably at a big loss if half of the costs of the combined iTunes / iPod ads had been factored in.)  Now Apple is spending big again on marketing its music product, but this time the ads are only for Apple Music so costs can’t be attributed to other parts of the business. Why this all matters is because it shows us just how seriously Apple is taking Apple Music and also its appetite for running it a loss leader.

Why Doesn’t Apple Just Buy Spotify?

One of the recurring questions around Apple’s streaming strategy is ‘why doesn’t it just buy Spotify?’.  Besides the fact it had already acquired Beats Music as part of the much bigger Beats purchase, Apple is not in the business of running other companies’ services.  Apple runs Apple services. This is because Apple is first and foremost a hardware business and its software and services are an extension of this – part of the device value proposition.  If Apple was a software and services business it would build Mac OS, iLife, iWork etc for other platforms.  Apple even made music production software Logic Mac only after buying it from eMagic.  iTunes is one of the stand out exceptions for this strategy but it is a legacy of when iPod was a PC / Mac centric device, where not being on Windows would have stymied iPod growth. (There is of course talk of Apple Apple Music becoming available on Android but if it does so it will only be because Apple wants to win back iTunes customers from Spotify.)

A Tunnel Vision Commitment To User Experience

The hardware-first / Apple-only strategy means that when Apple does buy other services it usually either assimilates them wholesale (remember LaLa?) or it strips them down to the bare bones and rebuilds them entirely (Beats Music).  This is all because Apple needs to own the customer relationship and customer experience in its entirety.  Apple’s tunnel vision commitment to user experience is the ideology that underpins this entire approach.  Which is why Apple didn’t buy Spotify.

Apple Could Make Most Streaming Margin By Promoting Spotify

In fact Apple could make a LOT more money if it simply decided to spend money marketing Spotify to iOS customers.

For argument’s sake let’s assume Spotify has somewhere in the region of 6 million US subscribers, that 60% of those are on iOS and that 60% of those iOS users pay via iTunes, Apple thus generates $8.4 million a month in subscription revenue from Spotify.  To generate the same amount of US subscription margin from Apple Music, Apple would need 16.9 million US Apple Music subscribers (assuming an operating margin of 5%).  In fact, in practice Apple will be in heavy negative margins with Apple Music due to its extensive marketing efforts.

So if Apple was in the business of music for making money it wouldn’t even buy Spotify, it would simply spend money marketing it to the Apple customer base.  But that has never been the Apple way and is patently unlikely to become the Apple way. Thus Apple will continue on its mission to own every ounce of the streaming subscriber’s user journey.  Unfortunately the rest of the marketplace has to try to figure out how to compete while at the same time vainly searching for a profit.