MARKET WATCH: What’s Happening? Google recently re-entered the music streaming business with a bang when it announced its new paid subscription service, YouTube Music. The company’s latest effort comes at a time when streaming has taken over as the music industry’s main growth driver. The space has become concentrated in recent years, leaving consumers to choose between several homogenous services. Which ones stand out?
Our Take: As the largest and most user-friendly on-demand streaming service around, Spotify is the unquestioned leader of the space. But its lead is not safe. Due to (as yet) unscalable licensing costs, Spotify—like its other pure-play streaming competitors—isn’t profitable. Yes, streaming is undoubtedly the new norm, especially for Millennials who prefer breadth over depth. But a tech giant with other complementary revenue sources (i.e., a FAANG that doesn’t need to make a profit on streaming alone) may be best-equipped to carry the format into the future.
Google recently introduced YouTube Music, a paid subscription service that allows users to stream songs, make playlists, and play music videos ad-free and on demand. While this isn’t Google’s first foray into the streaming music business, their previous offerings (most recently, Google Play) have been eclipsed by the likes of Spotify and Apple. The revamped service indicates that Google is out to claim a bigger share of what’s quickly turning into a crowded space.
In a few short years, streaming has become the lifeblood of the music industry. According to the latest annual report from the Recording Industry Association of America (RIAA), revenues from recorded music increased 17% in 2017 for the second year in a row; most of that growth was attributable to paid music subscriptions. Streaming—a category that includes both subscription services and free, ad-supported options—is now the largest source of music industry revenues (65%), far exceeding physical sales (17%) or digital downloads (15%). Though total revenue remains a fraction of its peak two decades ago, the rise of streaming has been a balm to an industry that for years saw only declines.
THE NEW STREAMING LANDSCAPE
As streaming has surged in popularity, so has the number of companies that have stepped in to offer their own services. Among the rivals to YouTube Music are Spotify, Apple Music, Pandora, Amazon Music, Tidal, Deezer, Slacker Radio, and Napster—and that’s just for starters. But consumers may have a hard time telling them apart, because the plans they offer are largely the same. Some focus on radio and others on-demand streaming; some let users listen for free with ads. But all provide the same core paid service: unlimited streaming with the ability to create playlists and radio stations, as well as listen to songs offline for $9.99 a month.
So where does each service stand out? YouTube Music and Pandora claim to have the best recommendations. YouTube Music selects songs based on Google’s considerable trove of user data; it will also suggest music based on your location. Pandora has its famed Music Genome Project, which it plans to recreate for podcasts. Spotify plays on the widest variety of devices and focuses the most on social features. Tidal and Deezer tout the highest audio quality. Amazon and Apple, meanwhile, make it easy for listeners who own their hardware to enjoy seamless playback. Apple Music, for instance, is the only streaming service that works on the company’s HomePod speaker.
Though the competition in paid streaming is fierce, there’s a clear frontrunner: Spotify. As of May 2018, the company had 75 million paid subscribers and a total of 170 million monthly active users. Coming in second is Apple Music with 40 million subscribers. To be sure, these aren’t exact comparisons: Many of these services aren’t available in the same countries, while others haven’t disclosed their subscriber numbers. Spotify also isn’t the most popular source for music streaming overall; that’s the free version of YouTube. Paid subscriptions, however, generate much higher revenue per user—and, over time, ad-financed content tends to be driven downmarket.
Yet even though Spotify rules the industry, it’s not profitable. That’s because the cost of music licensing is so high and will continue to be as the company grows. Furthermore, unlike Big Tech, Spotify can’t afford to compete on pricing. It’s no coincidence that the two companies offering the deepest discounts on streaming are Amazon and Apple. And with Google trying again to enter this space, Spotify is facing another competitor with unmatched negotiating power and money to burn. In order to become profitable, it needs to either cut its music costs or pursue other sources of revenue. The company has started offering advances to indie artists and managers who license their music to Spotify directly—the first sign it may have long-term ambitions to produce content, Netflix-style.
GENERATIONAL TRENDS
What role might generational preferences play in Spotify’s ability to maintain its lead? The data are mixed. On the one hand, according to the RIAA, Millennials are only slightly more likely than their parents to stream music—but they’re twice as likely to be paid subscribers. And among Millennials who subscribe and those who would consider it, Spotify is the most popular choice. A 2016 study from Northwestern University found that when it comes to music discovery, young people most value convenience, lending support to Spotify’s strategy to be available on as many platforms as possible.
On the other hand, current or would-be subscribers may always be outnumbered by free listeners. According to the Northwestern study, young people are still most likely to discover music the old-fashioned way: through recommendations from friends or FM radio. In fact, the most popular sources among Millennials for new music are YouTube, Pandora, and FM radio. Discovering music through Spotify-centric routes, such as shared playlists, is less common. Free options are still seen as the most accessible and convenient to find and listen to music—though this may change. Both Pandora and YouTube are experimenting with higher ad loads in an effort to effectively annoy people into subscribing.
Whether paid or free, Internet radio or on-demand, there’s no question that streaming has become the new standard for the industry. The records and CDs that Silent, Boomers, and Xers stockpiled as youth have been replaced by digital libraries. With this has come a shift toward breadth over depth: Listeners are now able to sample music of all genres widely and quickly, creating an environment in which young people can invest much less energy into a single artist than Boomers did.
Millennials have given rise to many “one-hit wonder” bands: They care less about a vocalist’s ideology or worldview (a Boomer obsession which once fueled “big album” purchases) than they do about how a single song sounds. They care less about witnessing a performer’s artistic virtuosity live than they do about simply hearing his or her music—or, in the case of an on-stage EDM computer—its music.
The new normal leaves the industry at a crossroads. There’s more music at our fingertips than ever before, but much less money to be earned from selling it. And unless Spotify and its ilk can close the gap, streaming’s reign may end as quickly as the era of digital downloads did. Keep in mind that any tech giant could easily move to gain strength in this area if it wanted to; a small but well-regarded player like Pandora, or even a big fish like Spotify, is within reach. The fact that none has suggests that these companies don’t see a bright future there. But Spotify is determined to prove them wrong.
INVESTMENT OPPORTUNITIES
What kinds of opportunities do investors have in this space? Among streaming music services, there are only two public options: Spotify and Pandora. The rest are either private companies or tech titans for whom streaming constitutes a tiny fraction of their business. Spotify, which debuted in April 2018, has met growth expectations so far but is not making a profit. It last reported an operating loss of $49 million. Pandora, which debuted in 2011, has seen some promising gains following a rocky few years marked by stalled user growth and executive turnover, but also has yet to turn a profit.
The biggest threat both companies face is the possibility of getting steamrolled by their Silicon Valley competitors. Neither Spotify nor Pandora has created a sustainable business model, and they cannot continue losing money indefinitely in the face of virtually identical competition that can afford to undercut them on price. They’ll be challenged even further if another tech company with deep pockets, like Facebook, decides to offer its own service.
Each company is trying hard to play to its strengths.
Spotify is by far the bigger service; it has a market capitalization of $31 billion and leads in paid subscriptions. It has 170 million active users across 65 countries, 75 million of whom subscribe. Spotify’s main strengths are (1) its early prioritization of on-demand music, which has driven its rapid subscriber growth; (2) its free-tier on-demand, which feeds the ranks of paid subscribers and was recently overhauled in an effort to make it even more attractive; and (3) its seamless ease of use across a multitude of platforms. While some analysts have urged Spotify to drop its free tier in order to improve margins and royalty rates, the service’s low barrier to entry is undoubtedly what has helped it grow so large in the first place. The company’s growing prominence is also what has allowed executives to begin exploring revenue streams that would have Spotify competing more directly with record labels.
With a market value of $2 billion (only 7% of Spotify), Pandora is much less valuable. Yet Pandora is doing much better in users on a relative basis: 72.3 million daily active users and 5.63 million subscribers—all in the United States. Though exact figures aren’t available, surveys indicate that Pandora may actually have more American users than Spotify. After several years of disappointing financial results, Pandora has expanded its focus beyond radio and has begun competing directly with Spotify after releasing its own on-demand streaming service. It’s also pouring money into improving both its audio and visual ad technology. Accordingly, Pandora’s strength is the rapid pace at which it is leveling the playing field with Spotify.
Bottom line?
Again, the greatest threat hanging over the future of both companies is the prospect of massive cross-subsidized competition from the tech giants: Apple, Amazon, Google, and (perhaps this is a shoe still to drop) Facebook. Music streaming is currently situated in their “kill zone.” For any of the FAANGs, the conquest of streaming would constitute a modest but attractive extra jewel in their portfolio. For Spotify and Pandora, it would spell ruin.
Think this scenario is unlikely? In that case, Spotify would be the better long-term play. But proceed with caution. In fact, the big tech companies are already undercutting the streaming companies on price. Apple Music offers a $99/year deal, considerably cheaper than 12 months’ worth of a paid Spotify or Pandora subscription (both would set you back $120). Amazon, meanwhile, offers its music service to Prime members for just $79/year. These developments were conspicuously absent in Spotify’s first-ever earnings report, in which CEO Daniel Ek stated that, “We don’t see any kind of meaningful impact on competition.” Famous last words? As I recall, that’s roughly what Mussolini said about the U.S. entry into World War II.
If, on the other hand, you think it’s inevitable that at least one of the giants will reach out and try to grab what it can take, then you might be wise to reverse your bet. Go long Pandora and wait for the eventual buy out. Currently, there’s no talk of acquiring the service; the closest Pandora has gotten to acquisition was a $480 million investment from Sirius XM last year. Yet considering how closely it now resembles Spotify in features and how much the company is undervalued ($25 per Pandora user versus $162 per Spotify user!), purchasing Pandora may just constitute the cheapest and fastest means to acquire major market share. And the acquirer gets to snatch up the company’s famed algorithms and a trove of listener data in the bargain.
