Final Exam Report

MSE – Game Thoeretic Business Strategy

DROM B – 8122: 060

Is Spotify sustainable in the Music Streaming Industry?

Submitted by

Shreya Modi (sm3901)

Abhinav Sharma (aus2101)

The advent of digitization of music has brought with it a significant rise in streaming music. Although digital downloads still have a dominant share in the US music industry, currently responsible for 37% of its revenue, it has been consistently declining. Although digital downloads declined by 3% from 2013 to 2014, the loss is revenue was compensated for by a 6% increase in revenue of the streamed music industry. In 2014, this industry grew by 29% to $1.87 billion, accounting for 27% of the total US music industry revenue.

This growth would have been less impressive without Spotify, which is among the fastest growing companies in the streaming music industry. Our peer group comprises of avid Spotify users. Discussions with them re-affirmed our belief in its popularity. It is convenient, can be used on different platforms and allows users to share playlists with their friends. However, the company is in loss. There are a number of factors responsible for this. In the next few sections of the paper we will evaluate some of these factors and recommend steps that we feel might prevent the company from a probable decline.

Streamed music can be free or paid. Paid subscriptions have seen a phenomenal rise over the past few years. It grew 26% year-over-year to $7.7 million in 2014. The category of streaming music includes subscription services (the paid versions of Spotify, Music Key, Tidal), streaming radio services (eq. Pandora, iTunes Radio) and non-subscription on-demand streaming services (YouTube, free version of Spotify). Let’s take a detailed look at Spotify and some of its competitors.

Spotify: Launched in 2008 in Stockholm, Sweden, this multi-platform app rapidly grew in popularity in the streaming music space. As of January 2015, Spotify had over 60 M users out of which 15 M were subscribers of it’s paid Premium service offered at $10 a month ($5 per month for students). It is currently available in 56 countries across the Americas, Europe and Australia. In February 2010, Spotify appointed serial entrepreneur Sean Parker to help it secure deals with major record labels to license its music. Subsequently, it entered the US market in July 2011 after receiving a second round of funding of $100 M from Northzone, the investor group. It partnered with various entities to establish an effective market entry strategy – the Rolling Stone magazine and SongKick among others, The Guardian and Last.fm were among some entities that promoted Spotify’s offering in the US market. Over time the company grew in valuation based on the different rounds of funding it received. (It grew from an initial valuation of a few million dollars to $1 Billion in 2011 and recently to $8.4 Billion. This latest investment by a group of Goldman Sachs partners pushed the company to exceed the current value of the US recorded music industry which is at $6.9 Billion.) Spotify introduced the “Connect” feature which allows users to sync the app and its activities across all devices with a single account. Also, it introduced features that allow the user to discover music that is popular among other users on the network and to share user’s own playlists via automatic Facebook feeds. The user also has the option to follow artists to keep up with latest music trends. Like most other competitors, Spotify has the option to stream songs at lower bit rates – 96 Kbps (to save cellular data usage) and higher bit rates – 320 Kbps (for enhanced, lossless content streaming).

Similar to its competitors, Spotify garners revenue via its subscription model and ad-supported streaming. A certain dollar amount is paid to every artist for each play of her song. The average royalty rate is between $.006 and $.009 per play. More recently, Spotify teamed up with Sony to power a new music service called PlayStation Music. The support received from the Sony project is expected to provide an additional revenue stream for Spotify. The methodology used by Spotify to arrive at its subscription model is quite interesting. It performed a market estimation on the annual dollar amount spent by an average American who consumes music through paid downloads and album purchases. It was estimated that the average spend is roughly $120 per year, which translates to $10 per month which is now their monthly subscription fee. Its competitors followed this methodology to arrive at their pricing strategies as well. Spotify received mixed reaction from stakeholders across the music industry. Whereas record label companies are relatively satisfied with the royalty received per play, artists are largely dissatisfied with the revenue model as they receive a very low share of that royalty. The points below will help to illustrate this point further.

(1) According to an info-graphic by David McCandless, an artist on Spotify needs over 4 M streams per month to earn roughly $1200 in total.

(2) Black Keys drummer Patrick Carney criticized the concept of music streaming services as being an infeasible option for artists. In response to Sean Parker’s statement on Spotify’s role in helping the music industry generate more revenue, he said, “That guy has $2 Billion that he made from figuring out ways to steal royalties from artists, and that's the bottom line. You can't really trust anybody like that."

(3) Some record companies have openly criticized the company and have withdrawn rights from Spotify to stream their music. For example, Projekt Records refused to partner with Spotify in 2011 because it believed that artists were being exploited and it didn’t want to be part of this “unprincipled” concept.

(4) As a sign of protest against it’s business model, Radiohead front man Thom Yorke pulled out his solo project work from the streaming service in 2013 and solo artist, Taylor Swift withdrew her entire discography in 2014. Several other bands such as the Beatles, AC/DC have rejected Spotify on a permanent basis.

(5) Artists such as Adele, Coldplay, Beyonce and Black Keys among others withheld their latest albums to a later release date on Spotify. This hampered the company’s reputation as well as its revenue.

In response, Spotify took a number of steps to try to improve their relationship with artists and record label companies. For example, they doubled the proportion of revenue paid in royalty to artists to about 70%. They started an “Artist Services” program with the aim of educating artists of the benefits of Spotify’s platform and how it will be financially beneficial for them. Spotify tried to propagate its contribution in the reduction of piracy of digital content. It stated on its website that if a free and legal alternative is given to people, they will pirate less. It used Sweden, Norway, Denmark, USA and Netherlands as an example to validate this claim. For example, the introduction of streaming music services led to a decrease in the number of pirated downloads in Norway from 1.2 Billion songs in 2008 to 210 Million in 2012.

YouTube: YouTube is a subsidiary of Google Inc. and a media behemoth when it comes to content consumption services. It was developed as a B2C channel to allow end users to upload, view and share videos. It has over a billion users who actively consume millions of hours of video daily. YouTube launched Music Key in November 2014. It is a paid music streaming service that replaced Google All Access. Along with ad-free music streaming in its premium subscription, Music Key provides integration with YouTube video channels and offline content viewing. Another key feature that it offers is music recommendation. YouTube has a cost advantage as compared to others in terms of license fees paid to record companies. It achieved this by threatening them that it will remove their content from YouTube if they don’t agree to its price offering. Also, to capture a large number of licenses, it partnered with Merlin Network – an aggregation agency that represents over 20,000 different label companies. Most of the revenue streams for YouTube Music Key comes from two sources. First, via advertisements of businesses through promotional videos. Second, via a subscription based model that charges $8 from premium users per month. This includes ad free songs and unlimited music play for the user.

iTunes: iTunes is a subsidiary under Apple Inc. It was originally designed as a complementary software for the iPod and was meant for music organization and synchronization. Over time, it evolved to become a media library where users could download and purchase songs, audiobooks, movies, TV shows and more. The iTunes platform bundles a number of features that makes it convenient for a user to

access its various services. These are Genius - which generates music recommendations, iTunes U - which provides university lectures, notes etc., Ping - a social networking platform for users to follow artists, and App store - to buy apps. Also, iTunes Radio, which is similar to Spotify, was launched in June 2013 on this platform. The iTunes Store is the largest music vendor in the world by revenue since February 2010. They achieved over 25 Billion digital song downloads worldwide by February 2013. It currently offers 37 M songs and a large number of other media content. Although iTunes Radio has only 8% market share, its business model is capable of generating big revenue for the iTunes Store. This is in the form of paid digital song downloads, in store App purchases, movie rentals etc. On its own, iTunes Radio generates revenue purely through a subscription based model like Music Key.

Pandora Radio: Pandora Radio was the original player in the music streaming space. It was launched in 2005 as a spinoff of the Music Genome Project. Though it is only offered in 3 countries, approximately 150 million active users give it an edge in terms of market share (31%). Its technology offering is superior than that of its competitors. It is platform agnostic and pioneers in providing customized recommendations. However, it significantly lacks in terms of its music database with just 1 M songs compared to Spotify’s database of 20 M songs. Larger competitors, like Apple and YouTube have even larger databases. Pandora generates revenue via a subscription fee of $5 per month, advertising and music retailing. Pandora carries out retailing via a third party, whereas iTunes does this on its own platform and Spotify doesn’t do it at all. In 2012, around $70 M revenue was generated from advertising and only $10 million from subscriptions. Among its customer base, a mere 5% paid for subscription services. One of its primary expenses is related to content acquisition which comprises about 50% of its total costs.

Tidal: Launched in October 2014, the Tidal music streaming service has created tremendous buzz from the very start. This service is backed by some of the biggest artists in the music industry and is spearheaded by Hip Hop artist Jay Z. This service is differentiated in the market on the basis of its music streaming quality. Its streaming service is in FLAC encoding which is the ultimate lossless encoding format for music. For example, while companies like Spotify offer an average bit play rate of 200 Kbps, Tidal provides its content at 1400 Kbps. This drastically increases the quality of music received by the end user. Besides offering a library of songs that span over 25 M records, Tidal also offers a catalog of 75,000 music videos, thereby enhancing the user’s browsing experience. Additionally, users of Tidal are exposed to exclusive content, blogs and news of the artists who are involved in the project. The artist portfolio includes the likes of Beyonce, Daft Punk, Usher, Jay Z, Alicia Keys and Madonna to name a few. Priding on the fact that they are the “first artist-owned” music streaming service, Tidal claims to provide the highest royalty rates to artists that is three times more than that offered by Spotify. Tidal currently operates in 31 countries and has 580,000 paid users. The uniqueness of the revenue model for Tidal also makes it an interesting player in the market. Tidal doesn’t offer free subscriptions for its service. It has two tiers of paid services – $10 and $20 per month. Some fans have expressed their concerns regarding its pricing policy and the fact that an average user might not be able to understand the importance of FLAC. Furthermore, FLAC requires expensive apparatus (headphones, speakers etc.) making it inaccessible to some fans. Moreover, FLAC uses high data rates on mobile devices, which is also a discouraging factor for many users.

Company Advantage Disadvantage Competition for Spotify?

YouTube Music Key

Free premium subscription for 6 months, Massive media content base, Large potential audience, Video streaming (Integration with YouTube’s offering), content sharing (social media), Music recommendation service, Brand power (Google)

Cannibalized their own user base with free YouTube offering, Very low market share

Potentially in 2016, after full launch

iTunes Radio

Massive media library, Large potential audience (iTunes users), Integration with other media offering on iTunes platform, Music recommendation service, Brand power (Apple), Strong revenue model

Comparatively low market share (8%), Only runs on Apple devices, offered in 2 countries

Yes, it is an aggressive competitor for Spotify

Pandora Radio

Large audience, Strong technology, Good revenue model, High market share (31%), Multi-platform

Limited reach, offered in 3 countries, Limited music

Yes, it is an aggressive competitor for Spotify

offering (runs on all devices) database, allows only 6 skips per hour

Tidal Good revenue model, offered in 31 countries, Backed by music artists (Brand power), Superior product (FLAC, Exclusive content and blogs, videos), Higher royalty payment, Large music catalog

Small audience due to price premium, very low market share, Negative response from users

Potential competition for Spotify, but may be targeting a niche market which is different form the regular music streaming business

Why is Spotify currently not profitable, even though it has high revenue growth in a rapidly growing industry?

Our analysis shows that Spotify is currently not profitable. The company has reported a cumulative loss of over $200 M since its launch in 2006. In 2013, it suffered a loss of $80 M. The points below elaborate some reasons why the company is in loss.

1. Its cost structure is such that it pays about 70% of its revenues in royalties. As a result, its margins don’t improve with a rise in subscription base. Unless it changes this structure, it will be difficult for Spotify to rise above its losses. It is further constrained by the record companies that don’t allow negotiation of royalty fees.

2. Its ad revenue isn’t growing as fast as its subscription base. Ad revenue is used to make up for the cost of the free music it provides. An insufficient ad revenue might make it difficult to meet expenses. On the other hand, the rapidly increasing subscription revenue indicates rising popularity.

3. Since Spotify has a stand-alone product, there is no other company to absorb its losses. It is purely running on venture capital funding to fuel itself through operating losses. On the other hand, the loss incurred by iTunes Radio is absorbed by Apple to some extent. Moreover, iTunes Radio, for example has alternate revenue streams (media retailing) whereas Spotify has limited revenue channels.

Analysis and Recommendations for Spotify

The team conducted a survey to gather user ratings on the desirability of different services offered by these companies. The features

included – access to large number of songs, media retailing, exclusive access to artist blogs etc. The WTP Advantage or Disadvantage

of each company was calculated with respect to Spotify. These values are given in the table below.

Company WTP Advantage with respect to Spotify*

Cost Advantage with respect to Spotify**

Total Advantage

Price premium offering per month

Existent in USA since

Market share % (Others = 15%)^

YouTube Music Key

3 2 5 8 2015 3%

iTunes Radio -1.63 2 0.37 10 2013 8%

Pandora Radio

-1.93 1 -0.93 5 2005 31%

Tidal 2.86 -2 0.86 20 2014 0%

Spotify 0 0 0 10 2011 6%

*http://bit.ly/1GUC6xu, http://bit.ly/1PhmsLJ (Links to the survey and responses)

**The Cost Advantage or Disadvantage values have been assumed. The assumption logic is given below.

Assumption validation:

1. YouTube has a cost advantage of 2 w.r.t. Spotify as it has more negotiating power when it comes to paying license fees. The

same logic applies to iTunes Radio as well. In fact, these companies did exercise this power and were able to get lower fees.

2. Pandora Radio has a different cost structure when compared to Spotify as it pays a certain fee on every song played. Unlike

Spotify, Pandora doesn’t pay 70% of its revenues as royalties. Hence, Pandora gains a minor cost advantage.

3. Tidal is at a cost disadvantage as it pays almost three times as much royalty fees compared to Spotify.

We can conclude that YouTube Music Key has a significant cost advantage as well as a WTP advantage. We can also observe that even

though Spotify has a WTP advantage over iTunes, it loses to iTunes due to its cost disadvantage. We can use similar reasoning to come

to conclusions for all other players with respect to Spotify.

Also, it is important to note that while Tidal has a significant WTP advantage due to its superior features, its WTP might differ across

different customer segments. For example, in our survey, we mostly interviewed students who are a segment that generally does not

subscribe to Tidal given its current premium price offering of $20.

We believe that adopting the following strategies will help Spotify decrease some of its disadvantages:

1. Expansion- The music streaming industry has an inherent element of network effect. Players such as YouTube and iTunes offer features like sharing playlists and following a friend. Moreover, their popularity adds to the network effect making them more likely to build a market share. We recommend that Spotify should try to set up its network in countries where similar companies have not yet entered.

2. Increase regional library collection- Currently, Spotify has a very limited collection of regional songs. Building on this collection further will help it gain popularity in different countries. For example, if Spotify expands to India, then offering a Hindi song library may help it attract a larger fan base than its competition.

3. Partnership- Partnership with aggregation entities will give them access to a large database of songs. Partnership with Merlin Networks worked well for YouTube and Spotify should try to benefit using a similar model.

4. Beta testing- Feedback collected by means of a beta tests will enable them to improve their product. Also, it will give them an idea of consumer’s preferences.

5. Promotions- Initial promotional discount for premium accounts will encourage consumers with free accounts on Spotify to switch to subscription-based accounts.

6. Improve artist relations – Spotify has been constantly blamed by artists for unfair royalty rates and has seen the withdrawal of multiple artists’ records from its catalog. Spotify should try to mend its relations with artists by sponsoring concerts, helping artists realize how they can monetize their albums through its platform etc. The company should also publicize its contribution in the reduction of piracy levels in Norway. This will help show artists that Spotify is dedicated in removing media piracy, which will be looked upon favorably

7. Bundling services - Including features such paid music downloads, blogs by artists, video streaming among others on a single platform might help attract users who now look for a one-stop shop for all their music needs. The company can also integrate services such as concert promotion and ticket retail and merchandising as additional sources of revenue

8. Brand Power – Signing exclusive contracts with established and upcoming artists to initially release their work on Spotify will help build the company’s reputation.

Will Spotify be sustainable in future? The Music streaming industry is predicted to grow. In order to survive, firstly Spotify will need to make profit and secondly, achieve a good market share. We believe that adopting the strategies we just discussed will enable Spotify to achieve these two targets. Following is the probable value gap analysis once Spotify reaches this desired state.

Company WTP Advantage with respect to

Cost Advantage

Total Advantage

Price premium

Existent in USA since

Market share % (Others = 15%)

Spotify with respect to Spotify

offering per month

YouTube Music Key

1.5 1 2.5 8 2015 3%

iTunes Radio -1.63 1 -0.63 10 2013 8%

Pandora Radio

-1.93 1 -0.93 5 2005 31%

Tidal 1.86 -2 -0.14 20 2014 0%

Spotify 0 0 0 10 2011 8%

1. Spotify can decrease its cost disadvantage with respect to YouTube and iTunes by negotiating better deals with record labels and

changing its business model. This power can be attained by an increase in market share, our recommendations for which were

discussed in the previous section. Instead of paying 70% of its revenue as royalty it can try to negotiate a flat fee per song.

2. Spotify can increase social media offering on its platform to decrease its WTP disadvantage with respect to YouTube. This can be

achieved by building a strong platform for friends to share music.

3. It can decrease the WTP advantage that Tidal enjoys due to its exclusivity by introducing exclusive Spotify sessions with popular

artists.

More importantly, there are some key insights we can make in terms of the sustainability assessment of Spotify: 1. Is the pie going to change in the future?

The pie is clearly not going to decrease. In the earlier sections we discussed how the music streaming business is growing rapidly and hence, the pie is increasing year after year. The important assessment here is whether other players are going to capture some of the pie. It is highly likely that, even with the best efforts made by Spotify, it will be at a WTP disadvantage of 1.5 and a cost disadvantage of 1 with respect to YouTube Music Key. (See figure above). Hence, when YouTube launches Music Key in full swing at the end of 2015, it will capture significant share of the pie from Spotify and other players. This may cause a threat to Spotify’s sustainability in the future. However, Spotify will be able to sustain itself against other competition –iTunes, Pandora etc. as it has a net value advantage compared to them (See table above). With the entry of YouTube Music Key, Spotify’s profit (Price – Cost) will seem to disappear.

2. Will customer’s WTP remain the same? This involves prediction of customer behavior and our offerings to the customers. With the recommendations provided above, Spotify should be able to maintain or increase WTP for its customers

3. Will supplier (record labels/artists’ royalty) costs increase? It is highly possible that as Spotify gets more dependent on record companies for licenses, these record companies might try to exploit Spotify by charging very high royalty fees. Currently, Spotify pays 70% of its revenue as royalty, and it only reached this rate after succumbing to pressure from artists (also a supplier) who continuously complained of low royalty fees.

4. Low barrier to entry Switching costs are low (cancellation of subscription, no penalty), low learning skill required (easy to use apps), Buyer’s willingness to go to “better” brands (YouTube, iTunes) may lead to unsustainability of Spotify. However, there is a high supplier side barrier to entry as record companies charge high royalty rates to license music. This may deter small players from entering the market.

However, there are some other factors that will play an important role in determining the sustainability of the company and the industry (pie) on the whole. For example, music piracy is a significant danger that the industry needs to tackle in order to flourish. In addition, there are other concerns such as dissatisfied music artists with low royalty fees. According to Digital Music News, as a result of the low fees, musicians earn $34.5 K annually and 42% of the musicians are forced to work part time jobs to support themselves. This can lead to a collapse of the pie itself.

A Game: There are a number of other factors that play in while analyzing a firm in this industry. Let’s look at a brief game which will help the reader realize the market price effects that arise due to the linkages in buyer preferences.

There are 5 firms who offer their services. P = Pandora, S = Spotify, IT =iTunes Radio, YMK = YouTube Music Key, T = Tidal. We assume

that there are many buyers, but only these 6 buyers B1, B2…B6 have a WTP > 0 for these services. These 6 buyers can be classified

into 6 different segments as each buyer has its preference specified in its corresponding box. For example, B1 represents a listener

who appreciates high quality music and hence is willing to only buy Tidal services. B5, on the other hand, doesn’t care much about the

music quality and is highly price sensitive.

Let’s assume that each buyer wants at most 1 service. Also assume, each service can handle at most 1 buyer at this time. The WTP for

each buyer in each segment is different and has been carefully estimated.

1. As there are 6 buyers and 5 firms, it can be concluded that B6 becomes the excluded buyer.

2. B5 will purchase Pandora if WTP(B5,P) – Price(B5,P) > WTP(B5,S) – Price(B5,S)

In other words, 10 – 8 > 11 – price(B5,S) price(B5,S) >9. Hence, Spotify is guaranteed to receive a price of at least 9.

3. B4 will purchase Spotify if, 12 – 9 > 12.5 – price(B4,IT) price(B4,IT) > 9.5. Hence, iTunes is guaranteed to receive a price of

at least 9.5.

4. B3 will purchase iTunes if 14 – 9.5 > 15 - price(B3,YMK) price(B3,YMK) > 10.5. Hence, YMK is guaranteed to receive a price

of at least 10.5.

5. B2 will purchase YMK IF 16 – 10.5 > 22 - price(B2,T) price(B2,T) > 16.5. Hence, Tidal is guaranteed to receive a price of at

least 16.5.

Hence, the price of Tidal can be affected by the price of other services due to different buyer segments. This happens all the time

in the real world, where one service or product gets undervalued or overvalued due to another buyer segment.

Hence, we see that the market is very dynamic and the price of one segment’s preferences influences the price of a company in

another segment. We believe that Spotify will be sustainable post implementing some of our recommendations. However, certain

other complex factors such as the one illustrated in the game should be kept in mind while evaluating a firm’s sustainability.

Sources and Bibliography:

1) RIAA: https://riaa.com/keystatistics.php?content_selector=research-about 2) Spotify website: https://www.spotifyartists.com/spotify-explained/ 3) Case study: Impact of Digitization on Music Industry in Recent Times – Prabha Susy Mathew 4) Statista:http://www.statista.com/statistics/190926/advertising-revenue-of-pandora-since-2007/

5) Wikipedia articles: http://en.wikipedia.org/wiki/Pandora_Radio#Advertising

6) The Guardian: http://www.theguardian.com/technology/2013/aug/01/spotify-pandora-streaming-music-profits

7) http://www.theguardian.com/technology/2014/nov/25/spotify-revenues-2013-losses-streaming-music?CMP=share_btn_tw

8) YouTube:https://www.youtube.com/yt/press/statistics.html,

https://www.youtube.com/watch?v=egShCjfvi9s

9) Bloomberg: http://www.bloomberg.com/bw/articles/2014-05-21/why-spotify-and-the-streaming-music-industry-

cant-make-money 10) NY Times: http://www.nytimes.com/2014/11/26/business/spotify-discloses-revenue-but-not-its-future-plans.html

Digital Music News: http://www.digitalmusicnews.com/permalink/2015/04/19/spotify-is-now-worth-

more-than-the-entire-us-recording-industry, http://www.digitalmusicnews.com/permalink/2014/02/18/profitless

11) Various articles and blogs:

http://soentrepreneurial.com/2011/06/16/the-story-of-how-pandora-radio-almost-died/

http://recode.net/2014/11/25/spotify-is-a-booming-billion-dollar-business/

http://www.michaelrobertson.com/archive.php?minute_id=358

http://www.theverge.com/2013/3/11/4080130/can-anyone-turn-streaming-music-into-a-real-business

http://www.billboard.com/articles/business/6327762/spotify-2013-financial-report-what-you-need-to-know

http://www.cheatsheet.com/technology/will-spotify-ever-be-profitable.html/?a=viewall

https://futureofmusic.org/blog/2013/10/17/how-does-itunes-radio-pay-artists

http://musicians.about.com/od/publishingandroyalties/g/Blanket-License.htm

http://www.macrumors.com/2014/03/11/itunes-radio-third-most-popular-us-music-service/

A full list of references can be found here. http://bit.ly/1GV0f71