Music Streaming & The Illusive Quest For Profitability

This week the music streaming company Rdio, started by Skype co-founder Janus Friis, revealed it is seeking bankruptcy protection in the US Bankruptcy Court for the Northern District of California. Pandora will be acquiring “key assets” from Rdio, for a price tag of $75M (in cash… more on that later).

While this may have come as a surprise to some, it is just proof of what everyone knows already but seems to be having difficulty in admitting: music streaming is based on a broken business model. Actually, a more accurate way of putting it is that it is extremely difficult (if not impossible) for a standalone music streaming business to be profitable and survive over the long term. The key word here is “standalone”. For example, let’s separate Apple Music from everything else Apple. If we look at how much money it makes and how much it costs to operate (including content acquisition costs), I am sure it is already making a loss. But Apple also has the iTunes business (transactional, as opposed to subscription-based, less risky, more profitable) and all this, of course, to drive sales of iPhones and increase customer captivity. So, Apple Music works for Apple as a loss leader. It is an ecosystem play. But as a standalone business, it wouldn’t survive.

Let’s look at the main standalone music streaming companies out there.

Spotify

This Music Business Worldwide article covers Spotify quite accurately, so I won’t go into much detail. But the key takeaway is this:

Revenues have been growing considerably. 45% from 2013 to 2014, which looks like great news, right? Wrong. The problem is that costs are also growing, in fact at a faster pace than revenues (49% over the same period). And here is the problem with Spotify – in fact, with all other music streaming services: the more money they make, the more they lose. The problem comes, of course, from the free ad-based streaming option.

The MBW article gives a glimpse of hope for Spotify, if the company changes some of its fundamental business model elements, including (i) paying lower royalties, and (ii) eliminating the free ad-based option. Unfortunately, both options seem highly unlikely. First, it is difficult to believe that record labels would go soft on music streaming and start accepting lower payments - particularly when, remember, there are other companies with music streaming services able to foot the bill (namely Apple, Google, Amazon, Samsung and Microsoft). Second, if the free ad-based option goes away, so will users. They would immediately move to one of the services owned by the companies I just mentioned which, again, can afford a loss-making ad-based option.

Deezer

Deezer has a business model similar to Spotify: on-demand music streaming, with free and premium options. It isn’t as well known to North Americans as Spotify or some of the other streaming music services, mostly because the Paris-based company has focused on markets in Europe and the rest of the world. But it expanded into the U.S. last year and is targeting growth outside Europe, which is why this year it filed for an IPO. However, Deezer quickly pulled out and postponed the IPO due to tough “market conditions” – which, in itself, is quite telling.

In the IPO prospectus, Deezer boasts its revenue growth. It rose by more than 52% in 2014 to $160M – faster than the growth rate of the overall subscription-music business. That’s great, right? Again… wrong. As with Spotify, licensing deals are extremely onerous and the company lost $30M in 2014 (even more than in 2013).

Not to mention that only 3.8M of its 6M paying subscribers are actually generating any revenue for Deezer – remember that the company got much of its early growth through bundling deals with telecom carriers, which means that in some cases the service got paid up front, but many of these so-called “subscribers” have never actually used the streaming network at all.

Tidal

Ha! Joking...

Pandora

Pandora is, as we all know, one of the most popular music streaming services, particularly in North America (it only operates there, Australia and New Zealand).  Pandora is an internet radio company, meaning that users are not able to choose which song or album they want to play – like Spotify or Deezer – but instead can play a particular station based on different criteria (artist, music genre, etc). It is a different business model with lower content costs – around 50% of revenues, as opposed to 70%+ for the on-demand services. But still, a broken model.  Pandora reported a loss of $30M in 2014. The first three quarters of 2015 have already accumulated a $150M loss, due to higher marketing spend and a $90M settlement with the RIAA and major labels concerning royalty payments for pre-1972 sound recordings.

With Rdio’s bankruptcy, Pandora announced it would acquire Rdio’s “key assets” for $75M. This move represents a potential shift from a primarily US-focused ad-supported radio streaming service to a global and riskier on-demand service (Rdio is available in almost 90 countries). Wall Street also didn’t like this move and Pandora shares dropped 7% on Tuesday.

So… what now?

At this point, it is becoming clear that the music streaming business is based purely on wishful thinking, hoping that someday it will pay off. It won’t. Fighting for lower royalty payments or getting rid of free ad-based options seems extremely unlikely.  So what can they do to have a chance to survive over the long-term?

Do a “Netflix”.

I’ll explain. It is extremely difficult for a company, any company, to be profitable and sustainable over the long-term, if its business is based purely on acquiring and distributing premium content. Particularly if free ad-based is a critical part of it. And not just with music, actually. Premium content (music, TV & movies) is expensive. So these companies must expand their business to areas where they do not depend as heavily on their suppliers (record labels, Hollywood studios).

Netflix realized this and started producing their own content – high quality content that easily competes with Hollywood – while at the same time becoming a viable outlet for talented writers, directors and actors. Companies like Spotify should attempt the same: attract, manage and work with talent, produce and distribute original content, move into higher margin music businesses like events. Become a one-stop shop for production, distribution, monetization, research & analytics, marketing, and live event promotions.

They should look at the data they are already sitting on. Find out what audiences are craving for. Produce the music industry version of “House of Cards”.

It won’t be easy. It will be extremely hard, in fact. But remaining as it is should not be an option.