The Future of Music Streaming: High Valuations and Low Margins

Article from my blog archives moved to Medium: Written: 4/1/2016

California Gurls by Katy Perry. This is the last song downloaded on my iTunes account. The wave of music streaming sites coupled with my first smart phone, the IPhone 4, ultimately overhauled the arduous process of updating my iTunes library and brought me into the on-demand music era.

The on-demand music streaming world has exponentially grown since I downloaded Katy Perry’s Teenage Dream album in 2010. Companies such as Spotify, Pandora, 8tracks, Tidal, Youtube, Deezer and Apple Music have fought and grasped at the 7 billion dollar digital music market, all yet to post positive returns. The recent 1 billion dollar convertible debt raising from Spotify has put the future of music streaming in the spotlight, begging the question whether music streaming companies can justify such a high valuation and operate solely as a music streaming service.

According to The Wall Street Journal Spotify raised 1 billion in convertible debt from TPG, Dragoneer, and clients of Goldman Sachs. This was Spotify’s 10th funding round since its inception 9 years ago, bringing the total funding to $2.27 billion. The reason the raising has caused a stir in the music and tech world is because the amount of capital, method of financing and the onerous terms associated with the debt.

The Wall Street Journal stated the investors will be able to convert debt to equity at 20% discount. If Spotify doesn’t IPO within a year, then they can convert debt to equity at a further 2.5% discount every 6 months until they IPO. Spotify will also pay annual interest on the debt that starts at 5% and increases by 1 percentage point every six months until the company goes public, or hits 10%.

Spotify following in Ubers footsteps by raising debt rather than equity seems to be preventative to a down round that could lead to a loss in momentum, talent and further investment. Spotify’s 8.5billion USD valuation as of June 2015 doesn’t technically change with the debt round but it asks the question can the company justify the valuation? One of its mutual-fund investors believes it can’t, marking down their stake. Fidelity Investments held its Spotify shares at $1,643 a share in January, down 27% from last August, according to regulatory filings.

Spotify isn’t the only music streaming service with investors questioning on-demand music streaming valuations and path to profitability. Competitors Deezers (valued at $1 billion) failed to IPO in late 2015, Rdio went out of business in 2015, 8tracks is still yet to close a crowdfunding round and Tidal is struggling with 3 CEO’s in 9 months and continual losses.

Spotify’s choice to avoid a down round and IPO could partially be attributed to their current financials and revenue model which raises questions on the viability of offering music streaming as a sole service. Spotify currently services 30 million paying subscribers and about 100 million who listen free with advertising, compared to about 10 million paying customers at Apple Music, 6 million total at France’s Deezer, and 1 million at Jay-Z’s Tidal. The 30 million premium subscribers at Spotify pay $9.99 a month which resulted in net loss of $197 million from $1.3 billion in revenue in 2014, the last year which it disclosed financials. Spotify makes losses, similarly to other streaming services, because it has to pay high fees to the music labels. Spotify pays 70% of revenues as royalties. Sony Music Entertainment, Vivendi’s Universal Music Group, and Warner Music Group can justify these royalties passed on to streaming services as they control about three-quarters of the $15bn-a-year global recorded music market.

The pinch felt by Spotify being unable to vertically integrate is felt by other streaming services. When Deezer filed for an IPO last year, its prospectus showed how hard it is to turn a profit in streaming: their cost of sales were 84 percent in 2014. Pandora Media has also struggled because licensing costs eat up half of their revenue. The only route to profitability for a company purely offering on-demand music streaming is to increase paid subscribers or increase the brand to grow advertising. For these reasons firms that solely provide on-demand music streaming need to evolve and learn by the success of similar industries such as Netflix. The subscription based video streaming site expanded from using external content to the introduction of their own media content. Adding to their core product provided the higher margin revenue streams, on-demand music streaming needs.

Pure music streaming sites such as Spotify and Pandora need to further innovate to keep big name competitors at bay. Apple Music, Amazon and the like are using on-demand music streaming as loss leaders; converting customers to purchase hardware and complementary products. These large corporations can maintain a low margin business as they do not have to perform for investors and can absorb losses through other business areas.

I cannot see the world moving back to the monotony of downloading music and updating an iPod, however, if companies like Spotify do not innovate or follow in the footsteps of firms that felt similar growing pains such as Netflix, they will be slaves to the entertainment conglomerates or consumed by the big name brands such as Apple or Amazon.